Interest plays a role in almost all aspects of personal finance, including savings, investing, credit, and loans.
Simply put, interest is the money earned or paid when someone makes or receives a loan. You can be paid interest for keeping money in a bank account, purchasing a bond, or making other investments. You can also pay interest when you borrow money through a loan, credit card, or other line of credit. Interest is calculated as a percentage of the loan.
It’s important to consider interest when choosing a financial institution, because the rate that you earn or pay can significantly impact your overall financial picture. For example, when you open a savings account, you will earn interest at a specific rate on a regular schedule. How much you earn depends on the interest rate the bank offers.
When banks discuss interest rates for their savings accounts, they’ll tell you both the nominal rate and the annual percentage yield (APY). The nominal, or named rate, is the rate they pay. The APY is what you earn in a year expressed as a percentage of your principal. For example, if you deposit $1,000 into a savings account with an annual interest rate of 5%, you’ll earn $50 that year for a total of $1,050. But if the interest compounds monthly (more on that later), you’ll actually earn about $51.16 for a total of $1,051.16, so the APY is slightly higher than the nominal rate, at 5.12%.
When determining the nominal rate, banks consider how much they are earning on loans and how much it costs them to borrow money from other banks. Both of these factors are affected by the Federal Reserve Bank.
The APY depends on the interest rate the bank pays and the compounding method, if any, that it uses.
What you actually earn depends on whether the account pays simple or compound interest. Simple interest is calculated annually on the amount you deposit. With compound interest (which can accrue daily, monthly, or quarterly), interest is added to your principal to form a new base on which you earn the next round of interest.
When interest compounds in a savings account, the base amount in your account always increases, though it may do so slowly. For example, if you deposit $1,000 into a savings account with a 5% interest rate, compounding annually, you’ll earn $50 in interest the first year for a total of $1,050. The next year, you’ll earn 5% of $1,050, or $52.50, for a total of $1,102.50.
Compounding interest is why you hear the phrase “the sooner you start investing, the better.” That’s because the interest you earn on your investments are reinvested to form a new base on which future earnings can grow. As that base gets larger, the potential for growth increases.
Some savings accounts, including money market accounts, may pay different rates of interest on different balances or different segments of your total balance. If the rate is tiered, the interest rate goes up as the account balance increases. A blended APY means that you’ll earn different rates on different segments of your balance. Generally, you’ll earn the highest rate only on the top portion of your total balance and lower rates on the bulk of the account’s value.
Interest plays a role in the use of credit as well. In fact, it’s the reason that you may pay more for buying with a credit card than you would paying cash. If you pay your credit card bill in full and on time, credit costs you nothing. However, if you pay only part of your outstanding balance, you owe interest on the unpaid amount. You also owe interest on any new purchases during the month beginning on the day of the purchase.
The most common method for calculating the amount of interest you owe on a credit card is based on the daily outstanding balance on your account, compounding daily. This is the flip side of compounding—instead of helping you grow your account value, it increases the amount you’ll need to repay to the credit card company.
Similarly, when you take out a loan, you have to pay back the amount you borrowed (principal) and the interest that accrues on that amount. Shopping around for a loan involves figuring out what your total cost will be, including both the principal and the interest. The term, or length of the loan, as well as any additional fees are also important factors.
A loan’s annual percentage rate (APR) provides a full view of the cost of a loan, because it includes the fees you pay to arrange the loan as well as the annual interest rate. Interest rates, and thus APRs, vary widely depending on what’s happening in the economy as a whole. What doesn’t change, however, is that you want the lowest APR you can find.
The term of a loan is also key to keeping your total cost as low as possible, simply because a shorter term means that you’ll pay interest for fewer years. For example, if you borrow $10,000 at 10%, you would pay $322.68 per month on a three-year loan and $212.48 per month on a five-year loan. But the total cost for the three-year loan would be about $11,590, while the total cost of the five-year loan would be $12,700.