How does interest work?

Key takeaways:

• Interest can add up quickly so it’s important to understand how it works.
• When you deposit money, you earn interest and when you borrow money, you pay interest.
• Many factors determine the interest rate you earn or pay—some you can control (such as your credit score or the amount of your deposit), and some you can’t control (such as the Fed or bond and securities markets).

Interest…you can earn it with your savings or pay it on your debt. And depending on how it’s charged or earned, it can add up quickly, so it’s important to understand how interest works.

Definition of interest

Interest is the price paid to use someone else’s money; it’s calculated as a percentage of the amount being loaned or borrowed. You earn interest when you make a deposit into a savings or certificate account because you are allowing the financial institution to use your money. When you borrow money through a loan or credit card, you pay interest for the benefit of using the lender’s money.

How does interest work?

When you borrow money = Pay interest

When you borrow money through a loan or a credit card, you must pay the lender to use their money. The amount you must repay includes the principal (the amount you originally borrowed) plus the interest (your cost of borrowing).

When you deposit money = Earn interest

When you deposit money into an interest-bearing account such as a savings or certificate account, you get paid interest by the institution that holds your account. Typically, the interest is added to your account balance, where it continues to grow.

How is interest calculated?

There are two basic ways to calculate interest.

Simple interest

Sometimes called a nominal rate, this interest is calculated annually based on the principal balance of the loan or account. For example, if you borrowed $10,000 at an annual simple interest rate of 5%, you’ll owe $500 in interest for each year. If your loan has no fees, the total amount you must pay after three years is $11,500.

Compound interest

With compounding, the interest you earn or owe earns interest itself. Personal loans and mortgages typically charge interest that is compounded. So, that same $10,000, borrowed at 5% interest compounded daily, will yield $1,619 in interest owed after three years, for a total of $11,619.

This extra $119 paid over simple interest may not seem like a big deal after three years, but compound interest keeps growing and becomes exponentially bigger over time. So, if you had a $10,000 loan at 5% interest compounded daily, you’d need to pay $34,813 in interest after 30 years—much higher than the $15,000 owed under a simple interest arrangement. Remember, though, that compounding works the same for the interest you earn through savings and certificate accounts; the longer you save, the more interest you earn.

Factors that affect interest rates

Interest rates are determined by many variables—some you can control and others you cannot.

• Amount of the loan or savings: Interest rates are partially dependent on risk, which correlates directly to the amount of money you’ve deposited or borrowed. Larger loans are riskier to a lender, so the lender balances that risk by charging a higher interest rate. In turn, you may find that a savings or certificate account with a bigger balance can earn a higher rate of interest.
• Term: Shorter-term loans generally have lower interest rates because they pose less risk to the lender over time. Savings certificates with longer commitments usually earn higher interest.
• For borrowers:
  • Creditworthiness: If you have a higher credit score, you pose less risk to the lender and so generally qualify for a loan with a lower interest rate.
  • Payment amount: When you make larger monthly payments, a lender may offer a lower interest rate.
  • Collateral: When a loan is tied to a piece of property, such as a car or a house, the lender incurs less risk since they can take over the property in case of loan default. This is called a secured loan, and interest is generally lower.
• Federal Reserve: The Fed raises and lowers interest rates to help keep our economy balanced. For example, if the economy is struggling, the Fed may lower interest rates to boost consumer spending, and vice versa. This impacts you since Fed rates affect the rates you pay or earn for auto loans, credit cards, savings accounts, and certificates—but not mortgage rates.
• Bond and securities market: Because they are longer-term loans, rates for mortgages are influenced by Treasury bond rates and mortgage-backed securities. Historically, when bond prices have risen, mortgage rates have dropped.

What is Annual Percentage Rate (APR)? Annual Percentage Yield (APY)?

Since both measure interest rates as a percentage of the principal amount, it’s easy to confuse the two but important to understand the difference.

APR is the amount of interest you’ll pay when you borrow money. It can include fees, which is why some call it the ‘real’ or ‘true’ annual cost of borrowing. When you are evaluating loan or mortgage options, use the APR for an accurate comparison. But make sure to compare loans with the same terms. Otherwise, those fee payments will be spread out over different timeframes, which changes the APR.

APY is the amount of annual interest you’ll earn when you save. It includes compounding, so you’ll earn more than the simple interest rate.

Common types of interest-bearing debt and accounts

Interest rates vary widely according to the type of account.

Auto loan

Often, your car is used as collateral, which means the lender can repossess the car if you are unable to make your loan payments. Because the lender takes on less risk, interest rates are generally lower for auto loans than for an unsecured loan.

Mortgage loan

Like an auto loan, your home serves as collateral for your mortgage, so if you do not make mortgage payments on time, the lender can take your home and sell it to repay the loan. Generally, shorter (15-year) mortgages have lower interest rates than 30-year mortgages.

Credit card

If you do not pay your credit card bill in full, interest will be charged on the card balance. For credit cards, the interest rate is the same as the APR, but credit cards can have fixed or variable APRs, and the APRs may vary according to what you’re doing (making purchases, cash advances, balance transfers, etc.). Interest rates for credit cards are generally higher than for other debt.

Savings account

Your credit union or bank will pay you interest in exchange for holding your savings; they then use your money to invest or lend to others.

Certificate account

Interest paid on a certificate account is generally higher than for a regular savings account since the certificate requires that your money remain deposited for a certain amount of time. 

Money market account

This account, which combines savings and checking features, usually has minimum deposit requirements and varying interest rates depending on the account balance.

Factors that affect how much interest you earn or pay

• Interest rate
• Amount of the loan or savings account
• Compounding frequency (if compound interest)
• Term
• For borrowers:
  • Repayment schedule
  • Payment amount

Very interesting

Regardless of whether you’re earning it or paying it, it’s important to understand how interest works. When you’re paying interest, for a credit card balance or a loan, it represents the true cost of what you’ve purchased. And when you’re earning interest, especially with accounts that benefit from compounding, your money will work even harder for you.