What Is an Interest Rate?

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Higher interest rates, as a term, is a double-edged sword. If it is associated with your savings or CD account it is a good thing, however, if it is the amount of money you pay on your credit card bill, not so much. 

You may be aware of how the Federal Reserve is increasing interest rates, but what are interest rates exactly? And how do they affect your financial life?

What Is an Interest Rate?

In simple terms, there are two ways interest rates can be defined and those fall into the camps of interest you pay or the interest you earn. It can either be the amount you are charged on a loan when you borrow money or the payment you receive on money you have deposited. It is expressed as a percentage that is considered the cost of borrowing or the benefit of saving. 

How Do Interest Rates Work?

With deposit accounts, your bank, credit union or other financial institution will pay you money. This is known as annual percentage yield or APY. When borrowing money, the interest rates you pay will fund the rates banks pay on deposit accounts. Essentially, when a bank loans you money, the interest you pay will be used to fund a bank loan to someone else. This will typically be at a higher rate thus making it a cycle of financing.

APY vs. APR

A good way of understanding the difference between the interest you earn versus the interest you owe is knowing what APY and APR mean.

• Annual percentage yield: The rate you earn on a deposit account such as savings, CDs or money market accounts. APY is done over a period of a year and includes compound interest. 
• Annual percentage rate: APR is the interest you pay on an account as well as any fees. This percentage is also calculated on a yearly basis.

Common Areas Where You Earn Interest

Deposit accounts, or accounts where you save or invest money, often offer the incentive of paying an APY. This rate is usually competitive or higher than other banks or credit unions. The following are examples of accounts where you get paid interest:

• Savings accounts
• High-yield savings accounts
• Certificates of deposit
• Money market accounts
• High-yield checking accounts

Common Areas Where You Pay Interest 

When you borrow money or take out either a short-term or long-term loan, it will have an APR attached. You’ll have to pay the APR on top of the loan estimate and closing costs. Here are common areas where you would pay interest:

• Mortgage interest rates
• Mortgage insurance
• Student loans
• Cash advances
• Credit cards

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Types of Interest

Financial institutions calculate interest on their products, such as loans or savings accounts, by using one of two methods: simple or compound interest. If you’re borrowing money, simple interest is to your advantage, while if you’re earning money on a CD or other savings product, compound interest is more beneficial.

Interest can also be fixed, meaning it remains the same for the entire length of the loan or term, or variable, which means that it can fluctuate.

Here’s the difference between the different types of interest and when they are likely to be applied.

Simple Interest

Simple interest is usually applied to auto, mortgage and personal loans.

Simple interest is calculated using the following formula:

• Principal balance x interest rate x term of loan (in years)

For example, if you borrow $14,000 at 12% interest for three years, you’ll pay $5,040 in simple interest. The calculation looks like this: $14,000 x 0.12 x 3 = $5,040.

So, if you borrow $14,000, you’ll have to pay back $19,040.

Compound Interest

Compound interest usually applies to deposit products, such as savings accounts, money market accounts and CDs. Additionally, most credit card issuers compound interest daily, which can add up fast.

Compound interest is calculated at set intervals, such as daily or monthly, but also may be calculated quarterly, semi-annually or annually. The interest earned is added to the principal, and the interest going forward is calculated using the new balance.

Here is an example of how interest compounds monthly when applied to a CD — if you put $15,000 in a three-year certificate of deposit with a 5% APR that compounds monthly, the total interest earned at maturity would be $2,422.

Fixed Interest Rates                                    

Fixed interest rates remain the same throughout the entire term of the loan. Personal loans and auto loans have fixed interest rates. Most mortgage loans — 92% — also have fixed interest rates, which means that your mortgage payment won’t change.

Variable Interest Rates

Credit cards not only have compounding interest, but they also typically have variable interest rates — unless you receive a special introductory rate, such as 0% interest for 15 months. Variable interest rates fluctuate based on the market and cause your credit card payment to increase.

Mortgage loans can also have variable interest rates, such as with an adjustable interest rate mortgage. According to Freddie Mac, the most common ARM is the 5/1 ARM, which means that the interest on the loan remains fixed for five years and then adjusts every year thereafter. This means that your mortgage payment will change annually after five years.

What Determines Interest Rates?

On a national average, the Federal Reserve sets the federal funds rate. This rate is reassessed eight times a year and is affected by several factors such as economic growth and conditions like inflation. 

For personal banking, when you borrow money, the interest rate you are offered can be affected by factors like your credit score or how much down payment you can afford. For example, if you have a higher credit score and a good amount of cash to put down, you will likely receive a lower interest rate. You would be a higher risk with a poor credit score or less money for the deposit.

Benchmark Interest Rates

Interest rates can fluctuate depending on things like current economic conditions or your credit score. Many financial institutions or products will base rates on benchmark interest rates. Benchmark rates are determined by both economic growth and inflation. Here are two styles of benchmarks set by the Federal Reserve and prime rates set by banks. 

• High benchmark rates: These rates indicate a higher cost to borrowing money and regulating activity that can increase inflation.
• Low benchmark rates: These rates are designed to encourage borrowing and spending activity in hopes of boosting economic growth.

Final Take To GO

Whether it is earning on a high-yield savings account or paying on a 30-year fixed-rate mortgage, knowing what is an interest rate and how they work is imperative. A good interest rate can mean a lot of different things depending on which account it comes with and whether you are paying or earning. Seek out high-interest rates when looking to open a new bank account, and make sure to research the lowest interest rates when it comes to taking out a mortgage or applying for a new credit card.

Cynthia Measom contributed to the reporting for this article.

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