Banks charge interest on loans because they allow you to use money to purchase homes, automobiles, etc. Credit card companies charge interest because they allow you to use their money to buy just about anything you want. Banks pay interest on savings and CDs (Certificate of Deposits) because you loan them your money to lend to other borrowers. Two things to keep in mind when discussing interest rates, the rate is usually based on one dollar and a length of one year.

To begin with the basics, we will break down an interest rate into monetary form. First take a dollar and convert it into 100 pennies. Now we convert the interest rate into pennies. Therefore, if your interest rate is 3% it equates to 3 pennies per dollar, 25% is 25 pennies per dollar, and so on and so forth. So the easiest way to understand it would be: an interest rate is the amount of pennies charged per dollar loaned.

There are two terms used to when discussing interest rates. APR & APY

The first is APR which stands for Annual Percentage Rate. APR is the yearly rate of interest offered for use of each dollar loaned. When banks or credit card companies are trying to get you to use their money rather than your own, they will usually display the APR which is lowest rate which they are willing to give. So in theory, if you was to borrow 100 dollars for a year, without making any loan payments during the year, and agree to pay interest with an APR of 5%, at the end of one year you would owe $105.00 

Loan amount is $100       APR is 5%    interest collected in one year is $5 which is 5% of $100.

$100.00 + ($100.00 x 5%) =     the first  100 is the amount of the loan , in the () you have the amount of the loan times APR or Annual percentage rate which will also be the amount of interest earned.

$100.00 + ($100.00 x .05) =     in this line we convert the percentage rate into a decimal so that we can calculate the amount of interest earned.

$100.00 + $5.00 = 105.00         in this line we add the amount of the loan and the interest earned from the loan to give us our new total after one year.

The second is APY which stands for Annual Percentage Yield. The APY, if not equal to your APR is usually higher than your APR. APY is the yearly rate of interest which is actually collected for the use of each dollar loaned for a year. You may wonder or ask "Why would there be more interest collected if I agreed to a certain APR?" The reason that the APY is higher than the APR is because of the terms of the loan which determine when interest will be calculated and collected. Below we will show what factors that cause the APY to be higher than the APR.

We will take the same loan amount as above $100, again without making any loan payments during the year, with the same APR of 5%, but this time we will add terms and conditions to the loan. The terms of the loan will state that interest will be calculated and  collected every 3 months.

Since there are 12 months in a year, interest will be calculated and collected 4 times a year. Now we must break down our APR into 4 parts as well. So 5% broken down into 4 parts or 5/4 is 1.25%. If the lender was to charge you 5% on the loan every 3 months then they would be charging a total of 20% (4 x 5%) for the entire year, but because the APR is 5% you can only be charged 1.25% every 3 months which will be a total of 5%. 

Loan amount $100      APR is 5%   APY is 5.08%  interest collected in one year is $5.08 which is 5.08% of $100.

Interest will be calculated and collected in the months of March, June, September, and December.

March - the First point at which interest is calculated and collected

$100.00 + ($100.00 x 1.25%) =    the first 100 is the amount of the loan, in the () you have the amount of the loan times the APR divided by 4

$100.00 + ($100.00 x 0.0125) =    in this line we convert the percentage rate into a decimal so that we can calculate the amount of interest earned.

$100.00 + $1.25 = $101.25           in this line we add the amount of the loan and the interest earned in the first 3 months, which gives us our new balance.

June - the second point at which interest is calculated and collected

$101.25 + ($101.25 x 1.25%) =    the first amount is the new balance (which is the loan amount plus the interest collected in the first 3 months). in the () you have the new balance times the APR divided by 4

$101.25 + ($101.25 x 0.0125) =   in this line we convert the percentage rate into a decimal so that we can calculate the amount of interest earned.

$101.25 + $1.26 = $102.51          in this line we add the new balance of the loan and the interest earned in the second 3 months, which gives us our newest balance.

September - the third point at which interest is calculated and collected

$102.51 + ($102.51 x 1.25%) =    the first amount is the newest balance (which is the newest balance plus the interest collected in the second 3 months). in the () you have the loan and interest times the APR divided by 4

$102.51 + ($102.51 x 0.0125) =   in this line we convert the percentage rate into a decimal so that we can calculate the amount of interest earned.

$102.51 + $1.28 = $103.79         in this line we add the new balance of the loan and the interest earned in the third 3 months, which gives us our newest balance.

December - the fourth and final point at which interest is calculated and collected

$103.79 + ($103.79 x 1.25%) =    the first amount is the newest balance (which is the newest balance plus the interest collected in the third 3 months). in the () you have the loan and interest times the APR divided by 4

$103.79 + ($103.79 x 0.0125) =   in this line we convert the percentage rate into a decimal so that we can calculate the amount of interest earned.

$103.79 + $1.29 = $105.08         in this line we add the new balance of the loan and the interest earned in the fourth 3 months, which gives us our final balance for the year.

In the above example you notice that the interest is calculated and added to the loan amount creating a new balance after the first 3 months. In the second three months the new balance is used to calculate the new interest payment rather than the original loan amount. When you use the original loan amount plus the interest collected to calculate your next interest payment, it is called compounding interest. It is the compounding interest which allows the lender to collect more money on a loan and causes the APY is higher than your APR.

There maybe other factors which may affect a loan, but for simplicity we have kept it to the basics. Also we have used a relatively low amount to keep it simple. When you consider loans in excess of $10,000 to $500,000 the interest really adds up.

In theory if your loan only calculates and collects interest once a year then your APR and your APY should be equal. The more you calculate and collect interest then the higher the APY which means that more money will be collected on the loan. Remember the term compounding? It is the term which will determine when and how often a loan calculates and collects interest. Interest can be compounded once a year, twice a year, monthly, and even daily. 

So when shopping for a loan or making an investment decision be sure to look at the 3 key factors. The APR, the APY, and the terms for compounding. Make sure when you are comparing different loans that you compare one APR to the other, as well as one APY to another. NEVER compare an APR to APY or it could cost you thousands of dollars in interest on your loan. 

Remember to never sign any loan documents without checking all three items. Ask your loan representative to show you all three items, and to explain them to you as well. Even if you already understand all three terms and know how to calculate them, it is still a good practice to have your loan officer show you in the paperwork and explain the APR, APY, and the compounding frequency. By asking these questions, you can find out if your loan officer is trying to help, you or help themselves. It will also allow you to find out if your loan officer is knowledgeable as well.