Financial Management: Core Concepts, Third Edition

5.1 How Financial Institutions Quote Interest Rates: Annual and Periodic Interest Rates

To begin our discussion of how financial institutions quote interest rates and why we sometimes refer to interest rates as the “price to rent money,” let’s look at a simple example. When you deposit money in a certificate of deposit (CD) at a bank, the bank is technically borrowing or renting money from you with a promise to repay that money with interest. Let’s assume that you purchase a CD for $500 with a promised annual percentage rate (APR) of 5%. The annual percentage rate (APR) is the yearly rate that you earn by investing or the charge for borrowing. Here it is 5%. Although the financial institution quotes the 5% interest rate on an annual basis, these ...