Interest rates and how they work
Your guide for understanding interest rates
Interest rates matter if you’re borrowing money or depositing it with a financial institution. If you’re borrowing, the interest rate is the amount you pay annually to borrow money — expressed as a percentage of the principal. If you’re depositing funds, the interest rate is the amount the bank pays you to hold onto your funds.
When interest rates increase, it can be a double-edged sword. High interest rates can make borrowing money considerably more costly over the long run, but earning a higher interest rate on savings helps you build wealth faster.
Key insights
- In the U.S., the Federal Reserve plays a big role in setting interest rates.
- Interest rates charged for borrowing money are normally represented as an annual rate, and you can be charged simple interest or compound interest.
- When interest is offered on a checking or savings account, the rate is typically represented by an annual percentage yield, or APY, and you’ll generally be offered compound interest.
What is interest?
Interest is a term that describes two things. If you’re borrowing money, interest is the amount you pay to the lender for access to the funds. If you’re saving money, it’s the amount the bank pays you to keep your money in its interest-bearing accounts. Interest on loans is typically represented by an annual. At the same time, savings products explain their interest terms using annual percentage yield (APY).
Note some interest rates are fixed, meaning they never charge, while other interest rates are variable.
What’s the difference between interest and APR?
According to financial advisor Chuck Czajka, founder of Macro Money Concepts in Stuart, Florida, the term APR, for annual percentage rate, describes the actual cost to a borrower for a loan, including fees.
For example, the APR on a credit card can be calculated based on the interest rate and any fees charged, such as annual and maintenance fees. The APR accounts for loan expenses other than interest, like closing costs on a mortgage.
If you’re shopping around for loans, you’ll want to compare APRs instead of interest rates because APR represents the total cost to borrow.
Czajka said that APR differs from an interest rate because "an expressed interest rate is just that, a rate exclusive of fees." When loans don't have any fees, the interest rate and APR can be the same.
What’s the difference between interest and APY?
APY describes how much interest you can earn on the money you deposit in a checking account, a savings account or another interest-bearing account.
APY represents the total interest an account can earn in a year. This rate is based on the rate and how often interest is compounded. Some accounts compound interest daily, monthly, quarterly or annually; the frequency of compounding makes a big difference in how much you can earn.
Fortunately, most bank accounts earn compound interest, meaning they pay interest on deposits and interest that has compounded in previous months and years. However, some accounts only earn interest based on the initial deposit. This concept is called simple interest.
How interest rates are set
Czajka notes that, ultimately, interest rates are determined by the supply and demand for loans and credit. In practice, the Federal Reserve lowers or increases rates in the U.S. to "ensure liquidity and stability in the economy," he said.
For example, throughout 2022 the Federal Reserve raised the federal funds rate, or the rate at which banks can lend to each other overnight. As a result, you may have noticed that interest rates are higher in 2022, and that borrowing money costs more as a result. You may have also noticed that interest rates are higher for various savings products, such as certificates of deposit.
When do I earn interest?
You earn interest anytime you deposit money in an interest-bearing account, such as an online savings account, a money market account or a CD. Regardless of which type of account you use to grow your savings, securing a higher interest rate (and a higher APY) will always help you grow your money faster.
When it comes to compound interest, a rate that's even a few percentage points higher can have a dramatic impact on the amount you earn over the life of the loan.
The chart below shows the power of compound interest. The figures below highlight how much interest you could earn on an initial deposit of $20,000 over the course of 25 years, with interest compounded annually.
| APY on $20,000 deposit | Interest earned over 25 years | Final balance |
|---|---|---|
| 4% APY | $33,316.73 | $53,316.73 |
| 6% APY | $65,837.41 | $85,837.41 |
| 8% APY | $116,969.50 | $136,969.50 |
| 10% APY | $196,694.12 | $216,694.12 |
| 12% APY | $320,001.29 | $340,001.29 |
When do I pay interest?
You pay interest anytime you borrow money, such as when you take out an installment loan, such as a mortgage, student loan, auto loan or personal loan. Obviously, paying a lower interest rate is always better; you'll pay less interest in each monthly payment you make, as well as over the life of the loan.
Most loans charge simple interest, although it's possible to pay compound interest on loans if your minimum payment is not large enough to cover the interest that accrues on your balance each month. With this type of loan, borrowers wind up paying interest on interest, leading to a much more costly borrowing experience.
Just like earning interest on deposits, paying a higher interest rate when you borrow money adds up quickly. Take the example in the chart below. These figures represent the amount of money (monthly payment and total cost of borrowing) you would pay toward a $350,000 mortgage with a fixed interest rate for 30 years.
| APR on $350,000 mortgage | Monthly mortgage payment | Total cost of borrowing |
|---|---|---|
| 4% APR | $1,670.95 per month | $601,544.38 |
| 6% APR | $2,098.43 per month | $755,431.71 |
| 8% APR | $2,568.18 per month | $924,538.75 |
| 10% APR | $3,071.50 per month | $1,105,741.04 |
| 12% APR | $3,600.14 per month | $1,296,065.09 |
Frequently Asked Questions (FAQ)
Does my credit score affect my interest rate?
When you’re borrowing money, your credit score can impact the interest rate you're asked to pay. People with good credit tend to pay lower interest rates when they borrow. In contrast, individuals with fair or poor credit tend to pay higher interest rates because they present more risk to the lender.
What happens when interest rates go up?
When interest rates go up, consumers pay more interest each time they borrow money. On the other hand, rising rates help savers earn more interest on their deposits into interest-bearing checking accounts, savings accounts, CDs and money market accounts.
Who benefits from higher interest rates?
Savers benefit from higher interest rates because they get higher returns on their deposits. Lenders also benefit because they make more interest on loans to borrowers.
What is considered a high interest rate?
While today's interest rates may seem high, interest rates have fluctuated over the years and at times have been significantly greater. For example, according to Freddie Mac, the average rate on a 30-year fixed-rate mortgage in October 2022 was 6.9%, higher than at any point since April 2002. However, in September and October of 1981, mortgage rates exceeded 18%.
Bottom line
Interest rates can impact your financial well-being on both ends of the spectrum — when you save and borrow. There are limits to what you can do to control the rate you earn or pay; factors within your control include keeping your credit score in great shape and comparing multiple lenders for borrowing and banking. By understanding interest rates and how they work, you can take steps to maximize the interest you earn and minimize the interest you pay.
Sources
- Investor.gov, " Interest ." Accessed Oct. 31, 2022.
- Interest.gov, " Compound Interest ." Accessed Oct. 31, 2022.
- Consumer Financial Protection Bureau, " What is the difference between an interest rate and the Annual Percentage Rate (APR) in an auto loan? " Accessed Oct. 31, 2022.
- Marcus by Goldman Sachs, " What Is The Difference Between APY and Interest? " Accessed Oct. 31, 2022.
- FICO, " How Can Your Credit Score Affect Your Mortgage Rate? " Accessed Oct. 31, 2022.
- Freddie Mac, " 30-Year Fixed-Rate Mortgages Since 1971 ." Accessed Dec. 5, 2022.
- Board of Governors of the Federal Reserve System, " What is the prime rate, and does the Federal Reserve set the prime rate? " Accessed Oct. 31, 2022.
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