Interest-bearing accounts, such as savings accounts, also allow you to earn interest in the form of a yield.
Interest is the price you pay to borrow money or the return you earn on savings or investments. For borrowers, interest is most often reflected as a percentage of the loan amount per year. This percentage is known as the loan interest rate. For investors and savers, interest is expressed in the form of Annual Percentage Yield (APY).
For example, when you put your money in a high-yield savings account, the bank pays you interest. The bank pays you interest for storing your money and using it to invest in other transactions. Conversely, when you borrow money to pay for a large expense, the lender charges you interest on top of the amount you borrow.
Interest rate structure for borrowing
Every time you borrow money, you have to pay that base amount (principal) back to the lender. In addition, you have to pay interest to the lender, which is usually set as a yearly percentage on the principal. These loans come in many different forms. They can be credit cards, student loans, car loans, mortgages, personal loans, and more. It’s important to understand how the interest terms and repayment requirements work.
For example, say you borrow $10,000 from a bank in a simple loan with an annual interest rate of 10 percent, and you pay the loan back in 5 years. Interest on a typical bank loan is added to your monthly payment and is usually compounded monthly. In this example, you would pay approximately $2,748.23 in interest over the life of the loan.
You can use Bankrate’s mortgage calculator to estimate how much interest you’ll pay on your loan.
How interest works when saving
You can earn interest through savings products such as high-yield savings accounts, money market accounts, and certificates of deposit (CDs). Traditional savings accounts are also available, but they offer much less interest than high-yield savings accounts.
Most savings accounts offer compound interest (more on that below), so the more money you put away, the more your savings will grow with compound interest, and the more interest your account will accrue.
Interest and APY
If you’re an investor or saver, understanding APY, the compound interest that financial institutions pay on savings and investments, can help you grow your assets over time. When you open a savings vehicle, such as a savings account or certificate of deposit, the listed APY will tell you how much you can earn in a year.
For example, say you have a savings account that pays 5 percent annual interest. This annual interest rate is a combination of simple interest and additional interest that is compounded monthly for one year. If you have $10,000 in the account, after one year you will have earned $500 in interest.
How are interest rates determined?
Interest rates can be fixed or variable depending on the type of product you have and the financial institution you use.
Credit Products For credit products like credit cards and loans, banks base their interest rates on a number of factors, including your credit score and your debt-to-income ratio. Lenders use these factors to assess your risk and see if you are creditworthy enough to repay the amount you borrow.
For example, let’s say you have a five-year, $30,000 car loan with a fixed interest rate of 6 percent. Each month, part of your $580 payment goes toward the principal, or the amount you borrowed. Another part goes toward interest. Your monthly payment stays the same, but the amount you pay toward principal and interest changes. Typically, you pay the most interest early in the loan, and your payments decrease over time.
Deposit Products
For deposit products like high-yield savings and CDs, interest rates are usually variable, meaning the interest rate changes with market conditions. With a CD, you can lock in your interest rate for a set period of time, but once that period is over, your interest rate can change depending on the interest rate set by the lender.
Simple and Compound Interest
There are two basic ways to calculate interest: simple interest and compound interest.
- simple interest
- With simple interest, interest payments are added to your monthly payments, but interest is not compounded. For example, a five-year $1,000 loan with 5 percent simple interest per year will cost you $1,250 over the life of the loan ($1,000 principal and $250 interest). Interest is calculated by multiplying the principal amount by the annual percentage rate (APR) and the term of the loan ($1,000 x 0.05 x 5).
- Compound Interest
- This is determined by continually calculating interest on the principal and the interest charged in the previous payment period. Compound interest is designed to produce a higher return, sometimes much higher than simple interest, by compounding the interest earned in previous periods. If you took out the same loan above and were charged compound interest, you would pay just over $1,332 over the life of the loan ($1,000 principal and $132 in interest).
For larger loans with long-term, high interest rates, compounding interest can significantly increase the total amount you pay, which is why it’s always important to check with your lender or bank whether simple or compound interest is applied to your loan or savings account.
Conclusion
Interest is a fundamental concept in personal finance. It has a major impact on personal financial decisions, including saving, investing, and borrowing. Understanding how interest works and the difference between simple and compound interest can help you make informed decisions about how to borrow and save.
— Freelance writer Dori Jin Bankrate contributed to updating this article. Renée Bennett This article was previously updated.
