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 probably paying interest to lenders.
Whether you earn or owe interest, it pays to get the best rates. But what is an interest rate exactly? And how does interest work?
Here’s a closer look at what interest rates mean for your finances.
In This Article
What Are Interest Rates?
In plain language, interest is the cost of using someone else’s money. But what is an interest rate? If you need a simple interest rate definition, 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.
Interest rates can be fixed or variable. A fixed interest rate stays the same; it doesn’t change. So, for example, if you’re buying a home you might get a 30-year mortgage at a fixed 3.2% interest rate.
Variable rates, on the other hand, can fluctuate over time. That’s because variable interest rates are tied to 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.
How Does Interest Work?
There are two things to consider with interest rates: where they come from and how they’re applied.
Interest rates can be determined by Treasury note yields or the federal funds rate. The Treasury note yield is driven by demand for U.S. Treasurys. Demand affects bond prices, which in turn affects mortgage rates.
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.
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.
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 Does Interest Work on a Savings Account?
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 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 interest compounds monthly, you’d earn $39.64 over a five-year period. Over 20 years, you’d earn $525.19.
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.
How Does Interest Work on a Loan?
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.
To calculate simple interest on a loan, you multiply the principal times the interest rate times the number of time periods. You can use this calculation to determine the monthly payment on a loan and the total interest you’ll pay.
For example, say you get a $300,000 mortgage at 3.2%. You choose a 30-year loan with a fixed rate and put $60,000 down. Using simple interest, your payments would work out to $1,037.92 and your total interest paid would be $133,651.37.
Getting a lower rate works in your favor since it means less interest paid total over the life of the loan. The actual rate you pay for a mortgage or any other loan can depend largely on your credit scores, income, and debt-to-income ratio.
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 cashback. 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, then no interest accrues. Under the CARD Act of 2009, the grace period has to last at least 21 days.
So the simplest way to avoid paying interest on a credit card? Pay your bill in full each month.
Interest and Checking Accounts
You might be wondering, is there interest on checking accounts? The answer is, yes, there can be. It just depends on where you decide to open a checking account.
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.
Opening an interest checking account along with a high-yield savings account can help you maximize your interest earnings. Again, it’s important to keep checking account fees in mind since those can nibble away at the interest you earn.
Interest can be a good thing if you’re earning a higher rate on a savings account or checking account. But, when it’s time to borrow, interest can cost you money. 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. Even a small difference in rates can have a big impact on your bottom line.