Is 1% per month equal to 12% per annum?

Understanding the Discrepancy Between Monthly and Annual Interest Rates

In the realm of finance, it’s crucial to discern the distinction between monthly and annual interest rates. Contrary to popular belief, a 1% monthly interest rate is not equivalent to a 12% annual rate. This discrepancy stems from the compounding frequency, which plays a pivotal role in determining the actual annual return.

Compounding and its Impact

Compounding refers to the process where interest is accrued not only on the principal amount but also on the accumulated interest from previous periods. This phenomenon leads to an exponential growth in the investment over time.

In the case of a 1% monthly interest rate, the interest is compounded monthly. This means that the investor earns interest on the principal amount and also on the interest earned in previous months. As a result, the actual annual return is higher than a simple 12% annual rate, which is calculated without compounding.

Actual Annual Return Based on Compounding Frequency

The actual annual return on a 1% monthly interest rate depends on the compounding frequency. The more frequent the compounding, the higher the annual return.

For example, if the interest is compounded daily, the annual return would be approximately 12.68%. If the interest is compounded semiannually, the annual return would be approximately 12.36%.

Conclusion

It is essential to note that monthly and annual interest rates cannot be directly compared. A 1% monthly interest rate compounded over a year will yield a higher annual return than a 12% annual rate without compounding.

Understanding the impact of compounding frequency is crucial for investors to make informed decisions when it comes to investment products such as savings accounts, bonds, and mutual funds. By acknowledging the difference between monthly and annual interest rates, investors can optimize their returns and maximize their financial potential.