Question 1

What is the difference between APY and APR?

Accepted Answer

APY (Annual Percentage Yield) includes the effect of compounding and shows what you actually earn on deposits. APR (Annual Percentage Rate) is the simple annual rate without compounding and is used for loans. A 5% APR compounded monthly has an APY of 5.116%. For savings, look at APY. For loans, look at APR.

Question 2

Does compounding frequency really matter?

Accepted Answer

Yes, but the impact depends on the interest rate. At 5%, the difference between annual and daily compounding is about 0.13% APY -- $12.67 extra per year on $10,000. At higher rates like 10%, the gap widens to about 0.52% or $51.56 on $10,000. For most savings accounts, the difference between monthly and daily compounding is minimal.

Question 3

What is continuous compounding?

Accepted Answer

Continuous compounding is the theoretical limit of compounding frequency -- interest compounds every instant. The formula is APY = e^r - 1, where e is Euler's number (2.71828). For a 5% rate, continuous compounding gives an APY of 5.127%, virtually identical to daily compounding (5.127%). In practice, daily compounding is the most frequent used by banks.

Question 4

How do banks calculate APY on savings accounts?

Accepted Answer

Most banks compound interest daily and credit it monthly. They calculate daily interest as (annual rate / 365) times your balance, accumulate it through the month, then add it to your balance. The APY they advertise already accounts for this daily compounding, so the number you see is what you actually earn over a year.

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