What is interest? Definition, how it works and examples
Key takeaways
- Interest can be charged when you borrow or earned when you save.
- When you charge something on a credit card or take out a loan from a financial institution (student loan, auto loan, mortgage, etc.), you’re charged interest for borrowing that money.
You can also earn interest in the form of a yield on interest-bearing accounts, such as savings accounts.
Interest is the price you pay to borrow money or the return earned on savings and investments. For borrowers, interest is most often reflected as an annual percentage of the amount of a loan. This percentage is known as the interest rate on the loan. For investors or savers, interest comes in the form of an annual percentage yield (APY).
For example, a bank will pay you interest when you deposit your money in a high-yield savings account. The bank pays you to hold and use your money to invest in other transactions. Conversely, if you borrow money to pay for a large expense, the lender will charge you interest on top of the amount you borrowed.
How interest works when borrowing
Whenever you borrow money, you are required to pay that base amount (the principal) back to your lender. In addition, you will be required to pay your lender the interest, which is typically an annual percentage of the principal, set for the loan. These loans come in many forms. You may encounter them in such forms as credit cards, student loans, car loans, mortgages and personal loans. Understanding how the interest terms and repayment requirements work is important.
For example, let’s say you borrow $10,000 from your bank in a straightforward loan with a 10 percent interest rate per annum (meaning per year), and the loan is payable in five years. Interest on a typical bank loan is added to monthly payments and is usually compounded monthly. In this example, you’d pay about $2,748.23 in interest over the life of the loan.
You can use Bankrate’s loan calculator to estimate how much interest you would pay on a loan.
How interest works when saving
You can earn interest in savings products like a high-yield savings account, money market account or certificate of deposit (CD). There are also traditional savings accounts, but they earn much less interest compared to high-yield savings accounts.
Most savings accounts offer compound interest (more on that below). The more you put into savings, the more your savings compounds, and the more interest earned in your account.
Interest vs. APY
If you’re an investor or saver, understanding APYs — the compounded interest that a financial institution pays you on savings and investments — can help you grow your wealth over time. When you open a savings vehicle, like a savings account or certificate of deposit, the listed APY tells you how much you will earn over a year.
For example, suppose you have a savings account with an APY of 5 percent. That APY accounts for the simple interest rate and the additional interest due to monthly compounding earned in a year. If you had $10,000 in the account, you’d earn $500 in interest after one year.
How are interest rates determined?
Interest rates are fixed or variable, depending on the type of product you have and the financial institution you use.
Credit productsWith credit products, like a credit card or loan, banks use a number of different factors to determine your interest rate, including your credit score and debt-to-income ratio. Lenders use these to evaluate your risk to see if you’re responsible enough with credit to pay back what you borrow.
Say you have a 5-year, $30,000 car loan with a fixed 6% interest rate. Every month, a portion of your $580 payment goes to your principal amount, or the amount you borrowed. Another portion goes to your interest rate. Your monthly payment never changes but how much you pay towards your principal and interest changes. Normally you pay the most in interest early on in your loan and slowly start to pay less.
Deposits products
With deposit products, like high-yield savings and CDs, interest rates are normally variable. That means interest rates change based on market conditions. For CDs, you can lock in a rate for a set amount of time, but once that term is up, the rate can change, based on what the lender sets.
Simple vs. compound interest
There are two basic methods to calculate interest: Simple interest and compound interest.
- Simple interest
- With simple interest, your interest rate payments are added into your monthly payments, but the interest doesn’t compound. For example, a five-year loan of $1,000 with simple interest of 5 percent per year would require $1,250 over the life of the loan ($1,000 principal and $250 in interest). You’d calculate the interest by multiplying the principal, the annual percentage rate (APR) and the length of the loan: $1,000 x 0.05 x 5.
- Compound interest
- This is determined by continually calculating the interest on the principal plus the interest charged for the previous payment period. Compound interest is designed to generate higher returns, at times much higher than simple interest, by compounding the interest earned in the previous terms. If you take out the same loan above but it charges compound interest, you’d pay slightly over $1,332 over the life of the loan ($1,000 principal and $132 in interest).
For large loans with high interest extended over a long term, the increase in total amount paid when interest is compounded can be significant. For this reason, it’s always important to ask your lender or your bank whether a loan or your savings account will have simple or compound interest.
Bottom line
Interest is a fundamental concept to personal finance. It has a considerable impact on our personal finance decisions, including saving, investing and borrowing. Understanding how interest works, as well as the distinction between simple and compound interest, can help you make informed decisions about how you borrow and save.
— Freelance writer Dori Zinn contributed to updating this article. Bankrate’s René Bennett previously updated this article.
