How Does Interest Work?
Depending on which side of the transaction you are on, interest is either the cost of borrowing money or the reward for saving or investing it. If you are a borrower, interest is a percentage of the loan amount you will owe the lender over a year, known as the interest rate. Conversely, if you are a saver or investor, you receive an annual percentage yield (APY).
For instance, if you borrow money, the lender charges you interest on top of the amount borrowed. In contrast, if you deposit money in a high-yield savings account, the bank pays you interest and uses the money to invest in other transactions.
Understanding how interest works helps you make smart financial decisions. Increasing the amount of interest received for savings and investments, as well as decreasing the amount paid on loans, helps increase your net worth.
How Interest Works When Borrowing
Borrowing money requires you to repay the loan amount, or principal, plus interest, typically an annual percentage of the principal. These loans can come in many forms:
Car loans
Student loans
Personal loans
Interest Rate vs. Annual Percentage Rate
Because a lender might charge other fees, you should compare interest rates and annual percentage rates (APRs) among lenders. An APR factors in the interest rate and other fees, helping you more accurately compare total costs.
How Interest Works When Saving
You can earn interest from the following financial instruments:
High-yield savings account
Certificate of deposit (CD)
Most savings accounts offer compound interest. The more money you deposit, the more your savings compound, and the more interest you earn.
Interest vs. Annual Percentage Yield
An annual percentage yield (APY) accounts for the simple interest rate and the additional interest earned through compounding, or earning interest on interest. Understanding the annual percentage yield (APY) of your savings or investments helps grow your wealth and increase your net worth.
When you open a savings account, CD, or other deposit product, the APY shows how much you will earn over a year. For instance, if you have $10,000 in a savings account with a 5% APY, you would earn $500 in interest after one year.
How Interest Rates Are Determined
Your credit history and financial health impact the interest rate you receive when borrowing money. Conversely, economic factors impact interest rates for savings vehicles.
Credit Products
A lender’s credit card, loan, or other credit product has a range of potential interest rates that depend on market conditions:
The lender uses your credit score, debt-to-income (DTI) ratio, and other factors to determine your interest rate.
These factors affect the likelihood that you will repay the amount borrowed.
A lender might charge a higher interest rate if they believe you are likely to miss payments or fail to repay the loan.
For instance, if you have excellent credit and room in your budget, you might receive a five-year, $30,000 car loan with a 6% interest rate and a $580 monthly payment. In contrast, if you have poor credit, you might receive a 13% interest rate on the same loan, increasing your monthly payment to $683.
Deposit Products
Interest rates on a high-yield savings account, CD, or other deposit product depend more on the economy than on your personal factors:
Financial institutions base their interest rates on market conditions and what competitors are offering.
You might receive a higher interest rate for depositing more money or having another account with the same bank.
Fixed vs. Variable Interest Rates
A fixed interest rate, common on car loans or personal loans, remains the same. Conversely, a variable interest rate, common on savings accounts and credit cards, can change over time.
You can choose a fixed or variable interest rate for student loans and mortgages. In contrast, you can lock in a rate on a CD, but it could change if you renew the CD.
Simple vs. Compound Interest
Simple and compound interest can be calculated on deposits and credit products.
Simple Interest
Simple interest is calculated on the original amount of money, or principal, you deposit or borrow. For instance, if you deposit $1,000 into an account that pays 4% simple interest annually, you will earn $200 after five years.
Compound Interest
Compound interest is calculated on your principal and the interest you have already earned. For instance, using the same $1,000 example at 4% interest compounded annually, you would earn approximately $217 in interest over five years. Over longer periods or with more frequent compounding, the difference can grow significantly.
A large loan with a high interest rate compounded over a long term can significantly increase the total amount paid. Ask the lender whether a loan or your savings account uses simple or compound interest.
*This information is for educational purposes only.
Do you have additional questions about interest? Let me know in the comments!
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