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- Interest is an amount that's paid on bank accounts or owed on loans.
- Banks use terms like Annual Percentage Yield (APY) and Annual Percentage Rate (APR) to indicate how interest impacts a bank product in a year.
- Interest rates on bank products can change over time.
Interest can have a significant impact on your money. High-yield savings accounts, loans, mortgages, and credit cards have interest rates, so knowing how interest affects these products can give you a better understanding of whether a specific option is suitable for you.
Here's what you need to know about interest whether you're borrowing or saving.
Introduction to interest
Definition of interest
In simple words, interest is a fee paid or owed on a specific amount. On loans, mortgages, and credit cards, it is an amount you owe on top of what you already have to pay. On bank accounts, it's an amount you'll earn based on your account balance.
Role of interest in finance
The role of interest is to encourage borrowing. With a loan, mortgage, or credit card, you typically want access to more funds. Hence, the institution charges you interest, so you can get a certain amount upfront. With a savings account, you're getting paid interest over time because you're keeping money in a bank account. This benefits banks because it increases their reserves, and they can use extra reserves to generate more money.
Types of interest
Banks may use certain terms to indicate how interest works on bank accounts or borrowing products. Below, is an overview of all the terms you may need to know:
- Simple interest: When a bank product has a simple interest, interest is calculated only on the initial amount.
- Compound interest: If a bank product says it compounds interest daily, monthly, or quarterly, that means it offers compound interest. Money grows more quickly through compound interest because it accumulates interest more frequently — you're getting interest on top of interest.
- Interest rate: This is a percentage earned on a bank account or paid on a loan. The interest rate may be different from the APY or APR because these percentages provide more information. For example, interest rates do not tell you how frequently something is compounded.
- Annual Percentage Yield (APY): APY tells you how much is earned in a bank account annually. It includes how frequently interest is compounded.
- Annual Percentage Rate (APR): APR tells you the cost of borrowing money through a yearly rate. It can apply to loans or credit cards. APR includes the interest rate, and for loans, it also factors in fees.
How interest is calculated
Calculating simple interest
If you're trying to figure out how to calculate simple interest on a loan or other bank product, you can use the simple interest formula, below:
Calculating compound interest
If you see that a bank product compounds interest daily, monthly, or quarterly, you'll need to use the compounded interest formula to account for all the interest earned.
Many savings accounts generally pay compound interest, and the higher the compounding frequency, the more you'll earn. Hence, the best high-yield savings accounts typically compound interest daily or monthly.
Here is the formula for compound interest:
You can also use Business Insider's compound interest calculator to determine how much interest you'll earn or owe.
Compound Interest Calculator
How banks determine interest rates
Interest rates on bank products vary at banks and can change over time.
"The rates are set by the institutions on deposit accounts. There are a lot of factors that can go into those rates. It goes along with the current economy," explains Sarah Wicker, manager for deposit account and IRA services at Georgia's Own Credit Union.
The Federal Reserve uses the federal funds rate as a tool for regulating economic activity, which can impact the interest rates of banking products. If the Federal Reserve raises the federal funds rate, mortgage and savings account rates generally go up. As a result, it may cost more to borrow money but you could also grow your savings more. When the Federal Reserve cuts the federal funds rate, the rates on these bank products will drop too.
Interest in mortgages
Current average 30-year mortgage rates are around 6% to 7%. As mentioned previously, the Federal Reserve indirectly impacts fluctuations in mortgage rates. Other individual factors can impact your mortgage rate, too.
For example, national average mortgage rates tend to be higher among people with people lower credit scores, according to data from credit scoring company FICO. The amount of your down payment, the type of mortgage you apply for, and the timeframe of your loan can also influence the mortgage rate.
Interest in savings accounts
Average savings rates offer 0.45% APY, and average CD rates pay 0.23% to 1.81% APY, according to the FDIC.
The main advantage of earning interest on a bank account is that you can accumulate some money based on your bank account balance.
You can find the most competitive savings account interest rates at the best online banks and credit unions. These institutions are more likely to offer high-yield savings accounts which are similar to traditional savings accounts except they pay significantly more interest.
There aren't necessarily any disadvantages to earning interest on bank accounts, but something to keep in mind is that interest earned by bank accounts is taxable. Bank account interest generally doesn't have a significant impact on taxes unless you maintain a high account balance and earn a lot of interest in a year.
Navigating current interest rates
The Federal Reserve raised the federal funds rate several times in 2023 to combat inflation, which resulted in mortgage and savings account interest rates going up. Mortgage rates and savings account rates are still competitive in early 2024, but it's likely that mortgage and savings rates will drop soon.
The Federal Reserve is getting closer to reaching its 2% target inflation rate, and many experts anticipate the first rate cut will occur sometime in 2024. When the Federal Reserve shows signs that it'll start cutting rates, mortgage rates and savings account rates will likely start to drop as well.
Interest FAQs
Some bank products have simple interest, like loans, and others have compound interest, like most savings accounts. Compound interest means you're getting faster — interest is accumulating on top of interest as well as the initial amount. Simple interest accumulates only on the initial amount.
The interest rate on a loan can determine how much you'll owe on top of the initial borrowed amount. The interest rate on a savings account can determine how much you'll get paid for maintaining money in your account.
Interest rates can fluctuate over time. When the Federal Reserve cuts or raises the federal funds rate, that will impact changes in interest rates.
Banks charge interest because they are giving you a certain amount upfront for you to use. Lending involves risk because there's a possibility you might not pay it back. Interest accounts for that to make sure banks let people borrow money.
Economic conditions can sway the Federal Reserve's decisions, and changes in the federal funds rates can influence interest rates. There are also personal factors that can determine interest rates on banking products. For example, if you're getting a mortgage, your credit score and the amount of your down payment are a few factors that can determine your rate.
