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Interest can be charged when you borrow money or get it from savings.
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When you charge something on a credit card or take out a loan from a financial institution (student loan, car loan, mortgage, etc.), you are charged interest for borrowing that money.
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You can also earn interest in the form of interest on interest-bearing accounts, such as savings accounts.
Interest is the cost of borrowing money or the reward for saving or investing – depending on which side of the business you are in.
For borrowers, interest is a percentage of the loan amount that you will owe throughout the year, paid to the lender. This percentage is known as the interest rate of the loan. For investors or savers, interest comes in the form of the annual percentage yield (APY).
For example, a bank will pay you interest if you put your money into a high-yield savings account. The bank pays you to hold and use your money to invest in other payments. Conversely, if you borrow money to pay for major expenses, the lender will charge interest on the amount borrowed.
Understanding how interest works is essential to making smart financial decisions. In this guide, we’ll break down the basics of interest, how it’s calculated and what it means for your loans, credit cards, savings accounts and more.
Whenever you borrow money, you are required to pay the principal (loan amount) to your lender. You will also need to pay your lender the interest, usually an annual percentage of the principal, set aside for the loan. These loans come in many forms, including credit cards, student loans, car loans, mortgages and personal loans. Understanding how interest rates and repayment requirements work is essential to managing debt wisely.
For example, let’s say you borrow $10,000 from your bank with a direct loan with an interest rate of 10% per year, and the loan is repaid over five years. In this example, you will pay approximately $2,748.23 in interest over the life of the loan.
You can use Bankrate’s loan calculator to estimate how much interest you can pay on your loan.
Expert advice: Fertility vs. APR
“In addition to interest, the lender may charge other fees. That’s why I recommend comparing annual percentage rates (APRs) between lenders, not just interest. The APR includes both the interest rate and any other fees, helping you compare total costs more accurately.”
— Pippin Wilbers, Bankrate editor
You can earn interest on savings products such as a high-yield savings account, a money market account or a certificate of deposit (CD). There are also traditional savings accounts, but they earn very little interest compared to high yield savings accounts.
Many savings accounts offer compound interest (more on that below). The more you put into savings, the more you save, and the more interest you earn in your account.
If you’re an investor or saver, understanding APYs can help you grow your wealth over time. The APY calculates both the simple interest rate and the additional interest you earn as a result of compounding. (Think of compounding as earning interest on your interest.)
When you open a deposit product, such as a savings account or certificate of deposit, the APY listed tells you how much you’ll earn in a year. APY makes it easy to calculate how much you’ll earn. For example, let’s say you have a savings account with an APY of 5%. If you had $10,000 in the account, you would earn 5% of that amount – $500 – interest after one year.
Read more: APY vs. interest rate
When you borrow money, your financial health and credit history are important factors that determine the rate you get. When you save money, the financial institution sets rates based on economic factors.
For credit products, such as a credit card or loan, each lender has a number of possible rates that depend on market conditions. But they use several factors to determine your interest rate within that range, including your credit score and your income-to-debt ratio. Lenders use these to check whether they can count on you to repay the loan. If they think you might miss payments or default on the loan, they will charge high interest to cover that risk.
Depending on the loan product, the range of possible rates can be large. Say you have excellent credit and plenty of room in your budget. You might get a five-year, $30,000 car loan with a fixed interest rate of 6% and a monthly payment of $580. But if your credit is low, you could get 13% interest on the same loan, bringing your monthly cost to $683.
With deposit products, like high-yield savings and CDs, the interest rate depends less on you and more on the economy: Financial institutions’ rates fluctuate based on market conditions and what competitors are offering. You may get a higher rate for depositing more money or having another account with the same bank, but your funds are not included.
Adjusted rates compared
A fixed rate does not change, while a variable rate may rise or fall over time. You may see fixed rates for auto loans and personal loans. Variable rates are common on savings accounts and credit cards. You can choose between both student loans and home equity loans. For CDs, you can lock in the amount for a set amount of time, but the rate can change when you renew the CD.
For both deposits and credit products, there are two basic ways to calculate interest: Simple interest and compound interest.
Simple interest is calculated only on the original amount of money you deposited or borrowed (principal). Although it is rarely used in savings accounts today, it is still a useful concept to understand interest.
For example, if you put $1,000 into an account that pays 4% simple interest annually, you will earn $250 after five years.
Formula: $1,000 × 0.04 × 5 = $200 interest.
Compound interest is calculated on both your original principal and the interest you have already earned. Many savings accounts, investment accounts and credit cards use compound interest.
Assuming the same example of $1,000 at 4% interest compounded annually, you’ll earn about $217 in interest over five years – slightly more than simple interest. Over a long period of time or with multiple combinations, the difference can increase significantly.
Note: This example assumes a single deposit with no additional contributions, to keep the comparison between simple and compound interest straight.
Calculates compound interest
The math for calculating compound interest is a little more complicated. Check out our compound interest calculator for a complete explanation – or let us do the math for you.
For large, high-interest loans spread over a long period of time, the increase in the total amount paid when the interest is compounded can be significant. For this reason, it is always important to ask your lender or your bank whether your loan or savings account will have simple or compound interest.
