Interest Rates and How They Work
Point of Interest
By understanding how interest is calculated and when interest works in your favor, you can get interest rates that make your money work harder for you – both as a lender and a borrower.
Managing money properly is a necessary part of adult life. To make sure you’ve put your money to work effectively, it’s important to have a solid understanding of interest rates and how they can affect you, both when borrowing money and making investments.
Interest rates can change daily, and even fractions of a percent in interest can translate to thousands of dollars extra over the life of a loan.
What is interest?
Interest is an additional amount of money earned on the principal balance of a loan. Interest exists to help encourage prompt repayment of a loan — the faster the loan is repaid, the lower the amount of interest that is charged. It also gives those who have money an incentive to lend it to others.
If you are the lender, you would earn interest in exchange for allowing someone to borrow your money. For most individual consumers, this happens when they lend money to the bank in the form of a savings account, certificate of deposit or other investment accounts. If you are the borrower, you must pay interest to the lender for the privilege of borrowing the money. This occurs most often when borrowing money from banks in the form of credit cards or personal loans.
How do I earn interest?
If you have extra money that isn’t needed for regular living expenses, you may want to consider investing the money in a savings vehicle that can earn you some interest in return. Banks make money by lending money to consumers, but to have the money available to lend, they need people like you to deposit money in the bank.
As an incentive, banks will offer you interest when you agree to keep your money in the investment accounts for a specified time. Here are a few examples of accounts that will pay you to store your extra funds.
Interest-bearing savings accounts
These accounts typically don’t offer much interest, but they are better than keeping your money in your checking account or a jar at home on your counter. They are one of the safest investment accounts, but you probably won’t earn much money in the long run. Savings accounts typically pay between a fraction of a percent and 2% interest, depending on the amount deposited.
Certificates of deposit (CDs)
These accounts pay a bit better than interest-bearing savings accounts, but not by much. CDs require that you lock your money in the account for a specific period — typically 1 to 5 years. Interest rates on CDs increase in proportion to the length of the lock-in time and the amount deposited into the account.
Money market funds
These accounts allow money to be pooled from multiple individuals and invested in low-risk securities funds. Unlike investing in stocks, money market funds are much more stable and predictable, though the interest earnings with these accounts are not guaranteed and depend on the amount invested and the type of fund chosen.
When do I pay interest?
Just as you earn interest whenever you lend money, you will likely pay interest anytime you borrow money (unless you have a close friend or family member willing to give you an interest-free loan).
Here are a few of the most common examples of when you may accrue interest that would have to be repaid:
Your credit card company will charge interest on any unpaid balance charged to your credit card at the close of your billing cycle. Credit card interest rates can vary from 0% — usually a short-term introductory rate for well-qualified borrowers — to 26% or higher for those with poor credit. Credit card companies will often have different rates for different types of transactions as well. Cash advances are usually charged more interest than regular purchases.
A portion of your mortgage payment goes to accrued interest on the loan each month. Interest rates on mortgage loans can be fixed, meaning the interest rate is the same for the life of the loan, or variable, meaning the interest rate can fluctuate periodically based on the terms of the loan. Mortgage loan rates can also change based on the length of the mortgage, the total amount financed and the amount of the down payment.
Like mortgage loans, a portion of your monthly car payment goes to accrued interest on the loan each month. Auto loan interest rates are also affected by the length of the loan, amount financed and the amount of the down payment, but the vast majority of auto loans are standard fixed-rate loans.
What determines my interest rate?
Interest rates are constantly changing and are set based on the health of the economy, industry standards, and several other factors.
When you borrow money
Interest rates are set based on your personal credit history, the amount borrowed, and the amount of collateral available. Creditors want to protect themselves if any amount borrowed is not repaid, so they will often charge higher interest rates to riskier borrowers.
When reviewing your credit history, many creditors will weigh the history on similar loans more heavily than other credit histories. For example, when granting car loans, banks will usually consider the payment history on previous car loans more heavily than late payments on medical bills.
When you earn interest
For interest rates on investments or savings accounts, your previous credit history doesn’t matter since the bank isn’t risking a potential loss. Instead, the amount of interest you can earn is set by current standard interest rates (often affected by the federal prime rate), the amount you are willing to invest, the type of investment account and the length of time you are willing to lend your money.
For example, the interest on a regular savings account will earn significantly less interest than a 10-year CD with a $10,000 minimum balance, since any money in a savings account can typically be withdrawn at any time and the minimum balances on savings accounts are lower.
Comparing interest rates to APRs
Often the terms “interest rates” and “APR” are used interchangeably, but there’s a significant difference. APR stands for annual percentage rate, and this figure includes the interest rate plus any additional costs, such as broker fees, loan origination fees or closing costs.
When taking out a loan, comparing APRs gives a more accurate picture of how much borrowing will cost over the life of the loan.
If, for example, two lenders offer the same interest rates, but one lender tries to make more with hidden fees and closing costs, examining the APRs for both loans can help spot the difference.
How to get the best interest rates
To ensure that you get the best interest rates, it is important to do thorough research on your financial partners and take steps to maximize the factors that have the greatest impact on your rates.
- Check your credit score: When borrowing money, be sure your credit score is strong before shopping around to different lenders. Save up a sizable down payment for any large purchases, and compare APR interest rates for the best overall comparison between lenders.
- Shop around: When earning interest on your money, be sure to shop around to find banks that offer the highest interest rates on savings and investment accounts. Evaluate your finances to know how long you can afford to tie up your funds and keep an eye on the federal prime rates to know the best times to make new investments at the highest earned interest rates. Same goes for earning money. Different banks offer different interest rates depending on the product, so make sure to check out all offers before you commit to depositing your money with one particular lender.