Interest… you can earn it with your savings or pay it on your debt. And depending on how it’s charged or earned, it can add up quickly, so it’s important to understand how interest works.
Interest is the price paid to use someone else’s money; it’s calculated as a percentage of the amount being loaned or borrowed. You earn interest when you deposit into a savings or certificate account because you are allowing the financial institution to use your money. When you borrow money through a loan or credit card, you pay interest for the benefit of using the lender’s money.
When you borrow money, through a loan or a credit card, you must pay the lender to use their money. The amount you must repay includes the principal (the amount you originally borrowed) plus the interest (your cost of borrowing).
When you deposit money into an interest-bearing account such as a savings or certificate account, you get paid interest by the institution that holds your account. Typically, the interest is added to your account balance, where it continues to grow.
There are two basic ways to calculate interest.
Sometimes called a nominal rate, this interest is calculated annually based on the principal balance of the loan or account. For example, if you borrowed $10,000 at an annual simple interest rate of 5%, you’ll owe $500 in interest for each year. If your loan has no fees, the total amount you must pay after three years is $11,500.
With compounding, the interest you earn or owe earns interest itself. Personal loans and mortgages typically charge interest that is compounded. So, that same $10,000, borrowed at 5% interest compounded daily, will yield $1,619 in interest owed after three years, for a total of $11,619. This extra $119 over simple interest may not seem like a big deal after three years, but compound interest keeps growing and becomes exponentially bigger over time. So, if you had a $10,000 loan at 5% interest compounded daily, you’d need to pay $34,813 in interest after 30 years—much higher than the $15,000 owed under a simple interest arrangement. Remember, though, that compounding works the same for interest you earn through savings and certificate accounts.
Interest rates are determined by many variables.
Since both measure interest rates as a percentage of the principal amount, it’s easy to confuse the two but important to understand the difference.
APR is the amount of interest you’ll pay when you borrow money. It can include fees, which is why some call it the ‘real’ or ‘true’ annual cost of borrowing. When you are evaluating loan or mortgage options, use the APR for an accurate comparison. But make sure to compare loans with the same terms. Otherwise, those fee payments will be spread out over different timeframes, which changes the APR.
APY is the amount of annual interest you’ll earn when you save. It includes compounding, so you’ll earn more than the simple interest rate.
Interest rates vary widely according to the type of account.
Often, your car is used as collateral, which means the lender can repossess the car if you are unable to make your loan payments. Because the lender takes on less risk, interest rates are generally lower for auto loans than for an unsecured loan.
Like an auto loan, your home serves as collateral for your mortgage, so if you do not make mortgage payments on time, the lender can take your home and sell it to repay the loan. Generally, shorter (15-year) mortgages have lower interest rates than a 30-year mortgage.
If you do not pay your credit card bill in full, interest will be charged on the card balance. For credit cards, the interest rate is the same as the APR, but credit cards can have fixed or variable APRs, and the APRs vary according to what you’re doing (making purchases, cash advances, balance transfers, etc.). Interest rates for credit cards are generally higher than for other debt.
Your credit union or bank will pay you interest in exchange for holding your savings; they then use your money to invest or lend to others.
Interest paid on a certificate account is generally higher than for a regular savings account since the certificate requires that your money remain deposited for a certain amount of time. Learn more about certificates »
This account, which combines savings and checking features, usually has minimum deposit amounts and varying interest rates depending on the account balance.
Regardless of whether you’re earning it or paying it, it’s important to understand how interest works. When you’re paying interest, for a credit card balance or a loan, it represents the true cost of what you’ve purchased. And when you’re earning interest, especially with accounts that benefit from compounding, your money will work even harder for you.
Looking for a great way to earn guaranteed interest on your savings? Consider a certificate account. Certificate accounts pay higher interest than regular savings accounts and start at just $500. Learn more »
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