To compensate lenders for making loans, borrowers have to pay interest on the account. However, multiple ways to compute interest exist, depending on how often the interest is compounded. Interest compounding refers to how often interest gets added to the account, which affects the effective interest rate on the account.
Annual compounding means that the interest that accrues on the account is added to the balance of the account once per year. For example, if you put money into a savings account that compounds interest only once per year, the interest that you earn over the entire year does not get added to your balance until the close of the year. Since the interest compounds only once per year, the annual interest rate is the same as the effective interest rate.
Daily compounding means that the interest that accrues on the account is added to the balance of the account every day. For example, if you take out a loan, the interest that accrues on the loan gets added to the amount you owe each day and immediately begins accruing additional interest for the following days. Since the interest gets added to the account each day, the effective interest rate is higher than the annual interest rate.
Converting from Annual to Effective Rate
To calculate the effective interest rate when interest is compounded daily, first convert the annual interest rate to a decimal by dividing by 100. Next, divide by 365 to find the daily interest rate and add 1. Then, raise the result to the 365th power. Finally, subtract 1 from the result and convert back to a percentage by multiplying by 100. For example, if the annual interest rate equals 4.8 percent, divide by 100 to get 0.048. Then, divide by 365 and add 1 to get 1.000131507. Then, raise 1.000131507 to the 365th power to get 1.049167344. Finally, subtract 1 to get 0.049167344 and multiply by 100 to find the effective interest rate when interest compounds daily is 4.92 percent when the annual interest rate equals 4.8 percent.
Knowing whether your interest compounds daily or annually helps you better budget for either the interest you were earn or money you will owe. When interest compounds daily, it increases the value of the of the account faster than if interest compounds only annually. If you have a savings account in which you are earning interest, daily compounding is better for you. However, if you borrowed money that you are having to pay interest on, you are better off with annual compounding because you will owe less money.
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