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Banking Basics

What Is An Interest Rate and Why Is It Important?

Interest rates can be tricky, and whether it’s for a credit card or savings account, it’s important to know your options. But what is an interest rate exactly? Here's a closer look at what interest rates mean for your finances.

Rebecca Lake • December 2, 2021

In This Article

  1. Interest rate definition
  2. Interest formula
  3. APR vs. APY
  4. How to calculate interest rate on a savings account
  5. How do loan interest rates work?
  6. How is interest charged on a credit card?
  7. Is there interest on checking accounts?
  8. FAQs
  9. Final thoughts

If you have a bank account, you might be earning interest on the money you deposit. And If you have student loans, credit cards, or other debts, you’re most likely paying interest to those lenders.

Either way, the interest rate is important since it’s the extra money you will pay on your debt or receive on your savings. Let’s look at the different types of interest rates and how they can affect your financial well-being. 

Interest rate definition

Simply put, an interest rate is the cost of borrowing money or the reward for saving it. Both affect your money significantly, and it helps to think in terms of borrowing or saving. 

  • On the borrowing side, an interest rate is the cost of borrowing over time, expressed as a percentage. 
  • With saving, the interest rate represents the amount you can earn on your money over time. 

As a borrower, a bank (or a credit union or other financial institution) will lend you money for a mortgage, car, or your education. Banks borrow other people’s money that they deposit to lend you the funds you need as a loan. The banks thank those account holders by paying them interest on the money kept in their savings and charge the borrowers interest on the funds lent out.

The interest the banks charge is also used to pay themselves or make a profit. Banks charge borrowers a higher interest rate than they pay depositors, and the difference is, again, their profit. Since banks compete with each other for both depositors and borrowers, interest rates consistently remain within a thin range of each other.

Interest formula

The interest rate formula allows you to calculate the amount of money you need to repay towards a loan or debt, and the interest earned over an investment or fixed deposits.The simple interest formula also helps in calculating the interest paid on credit cards. 

The simple interest when given the interest rate can be calculated by the following formula:

Simple Interest = principal × interest rate × time

How to calculate your interest 

Here’s an example of how to put the formula to use.

If you take out a personal loan for $5,000 and the interest rate is 30%, what is the simple interest amount you will pay the lender? No problem, let’s figure this out. First, look at all of the numbers. 

Principal = $5,000

Interest Rate = 30%

Time = 1 year

Now using the formula, plug in your numbers:

Simple Interest =  5,000 × 30% × 1

Simple Interest = $1,500

 

How does interest work and how are rates determined?

A great question most people have is, how do interest rates work and where do they come from?

Interest rates are determined by the U.S. Treasury note yields or the federal funds rate. The Treasury note yield is driven by demand for U.S. Treasury. Demand affects bond prices, which in turn affects mortgage rates. The fed funds rate affects the nation’s money supply and, thus, the economy’s health. Typically, a country’s central bank (the Federal Reserve in the U.S.) sets the interest rate, which banks use to determine the interest range they offer to customers.

The federal funds rate is the interest rate at which banks borrow and lend between themselves overnight. This is the rate banks use as a benchmark for setting rates on things like car loans, credit cards, and savings accounts. 

The interest rate charged by banks is determined by many different causes, including the state of the economy. Economies are in great shape during periods of low-interest rates because borrowers have access to loans at inexpensive rates, and take out more money. Since interest rates on savings are low, businesses and individuals are more likely to spend and purchase riskier investments, which in return, fuels the economy. 

In terms of how interest rates are applied, it depends on whether you’re borrowing or saving. If you’re getting a loan, banks can use your credit history, income, and other financial details to decide what rate to charge you. If you’re opening a savings account, your interest rate usually hinges on where the federal funds rate is set. While governments favor lower interest rates, they eventually lead to market insecurities, where demand beats supply, causing inflation.

APR vs. APY

When you’re talking about interest rates, you’ll probably hear the terms “APR” and “APY”. They sound similar but they mean different things. 

APR (Annual Percentage Rate) is used when you’re loans or credit cards. The APR reflects the annualized cost of borrowing money when the interest rate and fees are factored in. 

APY (Annual Percentage Yield) represents the amount of money you could earn in interest over the course of a year. You’ll hear this term used when talking about savings accounts or other deposit accounts that earn interest.  

Between the two, APR uses simple interest while APY uses compound interest. Simple interest is calculated based on the principal loan amount. Compound interest is based on the principal amount, plus the interest that accrues over a set time period. 

How to calculate interest rate on a savings account

When you put away money using a savings account, compound interest is your best friend. The interest earned on your account is compounded and in return, given to the account holder as technically “free money,” for letting the bank use the deposited funds. If you have a savings account or plan to open one, your interest rate and APY can tell you how much your money will grow over time. 

Again, the APY is based on the interest rate and how often interest compounds. Depending on the terms of your savings account, interest might compound daily, monthly, quarterly, or yearly. 

To calculate interest on a savings account, you’ll need to know:

  • Your starting balance
  • Interest rate
  • Compounding frequency

You’ll also need to take into account any additional contributions you make to savings over time. The easiest way to calculate compound interest for a traditional savings account, crypto savings account, money market account, or CD is to use an online savings calculator

For example, say you open a savings account with $1,000. You plan to deposit $100 per month and you’re earning a 0.20% interest rate. If the interest compounds monthly, you’d earn around $40 over a five-year period and approximately $525 over a 20 years period.

The higher your interest rate and APY, and the more often interest compounds, the more your savings can grow. Just keep in mind that any fees you pay, such as monthly maintenance fees, can take away from the interest you earn. 

Also remember that interest rates can differ between savings accounts. Traditional banks, for instance, may offer lower rates compared to a high-yield savings account online.

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How do loan interest rates work?

Loans can use simple interest or compound interest to determine your cost of borrowing. But typically, if you’re getting a mortgage, car loan, or student loan what you’ll pay is based on simple interest. Getting a lower rate works in your favor since it means less interest paid total over the life of the loan. 

When making a payment toward a loan balance, the funds are split between the principal amount of the loan (the total you borrowed) and the interest. As you repay a loan, you may follow an amortization schedule. This is the timeline of how your payments are split between the principal and interest even though your monthly payment remains the same.

With these loans, the first payments are usually interest-heavy, meaning less of the money you are paying each month goes toward paying your principal loan amount. As time passes and you get closer to your loan payoff date, the roles reverse. Toward the end of your loan, the lender takes the majority of your monthly payments and applies them to your principal balance and less toward interest fees.

How is interest charged on a credit card?

Credit cards can offer a convenient way to pay and some pay you back in the form of points, miles, or cash back. But when do you pay interest on a credit card, and how is it calculated? 

Again, credit cards can use an APR to determine your interest charges. This APR includes a variable interest rate as well as fees, such as an annual fee. Your APR can be tied to your credit scores; a higher credit score usually translates to a lower APR and vice versa. 

Interest applies when you carry a balance on your card. To find out how much interest you’re paying daily, you divide your APR by 365. This is your daily percentage rate. Your credit card company then multiples this daily percentage rate by your balance to determine how much interest to charge. 

No interest charges apply during the grace period. This is the window of time between the end of the billing cycle and your minimum payment due date. If you pay off your balance in full during the grace period, you don’t pay any interest. 

A high interest rate on a credit card can end up costing you big bucks. So, the simplest way to avoid paying interest on a credit card? Pay your bill in full each month. 

Is there interest on checking accounts?

You might be wondering, interest applies to most financial decisions, but can you earn interest on a checking account? You definitely can, however it depends on what type of checking account you open and where it’s held. 

High-yield checking accounts or high-interest checking accounts can pay competitive rates on checking account balances. You get all the regular features of a checking account with the added benefit of earning interest on the money deposited.

Opening an interest checking account along with a high-yield savings account can help you maximize your interest earnings on the money you aren’t using. Again, it’s important to keep checking account fees in mind since those can nibble away at the interest you earn.

FAQs

What’s the difference between a fixed and variable interest rate?

Interest rates are either fixed or variable. A fixed interest rate stays the same and never changes. Variable rates, on the other hand, can change or fluctuate over time. Variable interest rates depend on an underlying benchmark rate. When the benchmark rate moves up or down, the variable interest rate does the same. Credit cards typically have variable interest rates, which can sometimes cost you more money if you carry a balance.

What’s the difference between simple and compound interest?

Interest can be either simple or compounded. The two differ based on the amount(s) they consider when being calculated. Simple interest relies on the principal amount of a loan. Compound interest uses the principal amount and the interest accumulating on that principal amount over time. Because of this, simple interest can be easier to figure out. 

How do I know if I am getting the best interest rate?

The 3 big credit bureaus encourage customers to shop around for different interest rates. You have 14 to 45 days to apply for different credit cards or loan options with the same effect on your credit scores as applying for one loan, so your score doesn’t drop. It is smart to browse your options to ensure you’re getting the best rate. 

A borrower that is considered “low-risk” by a lender will have a lower interest rate. A borrower that is considered high-risk will have a higher interest rate. To get the best rates, you’ll need a very good credit score. If possible, improve your credit score before you apply for credit cards or loans.

Final thoughts

Interest doesn’t have to be a threat. It can be a good thing if you’re earning a higher rate on a savings or checking account. But, when it’s time to borrow, interest can cost you money. 

Practicing good financial management and habits can ultimately help with keeping your interest rates in check. Good credit can help with getting you the best rates, and making extra payments will usually lower your principal amount even faster. 

Whether you need to open a new bank account or take out a new loan, it’s important to shop around for the best rates. The best rate can make a big difference to your savings goals and overall financial health!

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