Interest Rate vs Annual Percentage Yield – Part 2 – Applications

Yesterday we came up with a formula that helps us find the Annual Percentage Yield based on the interest rate a bank offers. Today we are going to check this formula and see if we can test how this applies to real, everyday life.

First,we will check the current interest rate for a popular online savings institution – INGDirect (www.ingdirect.com) – to see if our formula works. They show the interest rate at 3.590% and the APY at 3.650%.

Second, we can check to see how much $10,000 will grow to at a 5% interest rate over 40 years compounding each month.

Finally, we will check to see which earns more money: $10,000 at 8% for 9 years, or $10,000 at 9% for 8 years?

For the first problem, lets organize our variables:

I = 3.590% (or .0359) This is our INTEREST RATE. (Note: This comes from the information in the problem.)

P = 1 month This is our PERIOD. (Note: The interest compounds monthly, so the period has to be one month.)

N = 12 This is the NUMBER OF PERIODS. (Note: The number of periods is 12 because there are 12 months/periods in a year and we and to check the Annual Percentage Yield.)

Ok, let’s take our equation from yesterday (1+(I/P))^N and plug the variables in:

(1+(.0359/12))^12 Simplify – Division.

(1+(.002992))^12 Simplify – Addition.

(1.002992)^12 Now we will need a calculator. After plugging it in our solution is:

1.036500769 Rounding gives us 1.03650 or 103.650% of our original investment after 1 year of compounding interest at 3.59%

That makes the Annual Percentage Yield 3.650%! The formula checks out!

For the second problem, lets start again by organizing our variables:

I = 5% (or .05)

P = 1 month

N = 480 (Note: We want to find the yield for 40 years. 40 years * 12 months (or periods) = 480 months (or periods). It is just like finding the APY for 1 year, but we are finding a similar percentage for 40 years and we will multiply this percentage by the Initial Principle.

$ = 10,000 (This is our initial principle.)

So we will use the formula from the problem above again, but since we want to find the dollar amount after 40 years, we need to multiply by the initial principle after we find the yield for 40 years. It will look like this: $ * (1 + (I/P)^N)) Let’s plug in the variables:

10000 * (1 + (.050/12)) ^ 480 Simplify – Division.

10000 * (1 + (.004166666)) ^ 480 Simplify – Addition.

10000 * (1.004166666) ^ 480 Use a calculator to figure out 1.0041666 ^ 480.

10000 * 7.358417 Multiply.

$73,584.17 – You will have 73,584.17 after 40 years.

For the last problem, lets organize the variables for the first part:

I = 8% (or .08)

P = 1 month

N = 108 (9 years * 12 months = 108 months)

$ = 10,000

Lets plug these variables into our formula:

10000 * (1 + (.08/12)) ^ 108 Simplify – Division.

10000 * (1 + (.00666666)) ^ 108 Simplify – Addition.

10000 * (1.00666666)) ^ 108 Use a calculator to figure out 1.00666666 ^ 108.

10000 * 2.04953026 Multiply.

$20,495.30 for the first part.

Now, lets organize the variables for the second part:

I = 9% (or .09)

P = 1 month

N = 96 (8 years * 12 months = 96 months)

$ = 10,000

Lets plug these variables into our formula:

10000 * (1 + (.09/12)) ^ 96 Simplify – Division.

10000 * (1 + (.0075)) ^ 96 Simplify – Addition.

10000 * (1.0075)) ^ 96 Use a calculator to figure out 1.0075 ^ 96.

10000 * 2.048922128 Multiply.

$20,489.22 for the second part.

So, the two totals are relatively close. The 8% for 9 years is $6.08 higher. There are two things to note based on this last problem. Time is the biggest factor in compounding interest. The longer that money is invested, the higher the return will be. For all of you people putting off investments, this equation proves that the earlier you get your money in, the better. It also shows the importance of shopping around (or choosing your investment wisely) in order to ensure the best rate possible. For example, you can make up for lost time by choosing an investment vehicle that has a high return. But there are many, many, many more factors that are involved in managing a portfolio – risk, target dates, goals, etc. This sort of math would just help compare one single facet of investing (time vs. rate) – and thats only practical for investments like savings accounts or Certificates of Deposit, where rates fluctuate much less. I am far from an expert on investing, but I just thought I would point out these trends.

The second thing to note is that we started with $10,000 and ended with more than $20,000. Both investments more than doubled over this time at these rates. I chose 8% for 9 years, and 9% for 8 years for a reason…because tomorrow we will explore The Rule of 72, as it applies to investing money. I hope these examples help explain the formula from yesterday, and that it takes some of the mystery out of how much money the bank gives every month for keeping your principle there. CD