Understanding interest rates are incredibly important because you will encounter them with nearly any financial tool you decide to use including loans, credit cards, savings accounts, and other investments.
We will teach you how interest rates can help you make money and how they can also cost you money. And understanding the differences, how it is calculated, and more will be quite useful in your financial journey.
Let’s get started!
Table of Contents
What Are Interest Rates?
Interest is an amount of extra money owed in a financial agreement such as the bank paying you interest on money in a savings account or you paying the credit card company interest on an overdue amount.
Besides the interest you gain on savings rates or what you owe on credit cards, you’ll find interest rates commonly used in other ares too.
Some examples being, personal loans mortgages, and even for loans like the purchase of cars, buildings and other consumer goods.
It’s important to maintain a good credit score, because this can help your interest rates when you go to borrow money. When you are considered low-risk, you tend to get better interest rates, which can save you quite a bit of money in the long-run.
Seeing interest rates in action
If someone loans you money then you will agree to pay them back the full amount plus interest. The extra money you pay them on top of the full amount is the interest. So, the interest is paid as a way to compensate the other party for loaning you money.
To calculate the interest owed in the most basic way, we multiple the interest rate by the loan amount to determine the interest owed.
Note: the way banks calculate interest is more complicated as it factors in time. See the example below for more detail.
Interest rate example:
You need to borrow $100 today. Your friend agrees to loan you the $100 today with the condition that in a month you will repay the $100 plus an extra 10% interest fee (as a way to compensate them for letting you borrow their money).
What is the total amount you owe them? How much of what you owe is interest?
- Principal Amount: $100
- Interest Rate: 10%
The $100 you borrowed is called the principal amount. Principal amounts never include interest.
That 10% extra that you agreed to pay is the interest rate. This rate will help you determine the interest you owe.
Calculate The Interest:
- Principal Amount x Interest Rate = Interest
- $100 x 10% = $10
What is the total amount you owe your friend? $110.
How much of what you owe is interest? $10. This was calculated by adding the $100 principal amount plus the $10 interest
How Can Interest Rates Make Me Money? How Can It Cost Me Money?
Depending on the financial agreement, you can earn money from interest rates and you can also owe money too.
Interest rates can earn you interest through a savings account, loaning money to someone, or other investments such as a bond or treasury notes.
Interest rates can make you owe interest when you borrow money through loans or owing interest from not paying off the full amount on a credit card.
In the example above you borrowed money from a friend therefore you owe them interest. But what if they borrowed money from you? Then you would have earned money from the interest they would owe you.
What Are the Most Common Types of Interest Rates?
The most common interest rates you will see are APR and APY.
APR stands for Annual Percentage Rate and APY stands for Annual Percentage Yield.
Do you have a credit card or looked at getting one? Then you have seen that credit card’s APR listed.
The APR on a credit card calculates the interest you would owe if you have an overdue amount.
Do you have a savings account or looked at getting one? Then you have seen that savings account’s APY listed.
The APY on a savings account calculates how much interest you will earn by keeping your money in a savings account.
What is the difference between APR and APY?
In the most basic sense an APR calculates the interest you will pay and the APY calculates the interest you will earn.
Also, even though APR and APY are both interest rates, they are actually calculated differently.
The different methods of calculation are technical and nuanced that were designed for the average person to never know there was a difference and to make the bank more money.
Since this is a money basics article, we won’t get into the exact calculations but wanted to make you aware that they are calculated differently and favor the bank to make more money.
Nerd Section Alert! Calculating Interest Rates
By this point you have the true basics about interest rates, APR, and APY.
The rest of the article builds upon the basics of interest rates and to show you some real life examples.
You may want to stop reading if math makes your head hurt. Or you can nerd out with me!
The “Interesting” Problem:
How much interest will you earn in a year if you put $100 in a savings account today with an APY of 7.0%?
The answer is $7.23. Keep reading to find out why it’s not $7.00.
Note: you probably won’t find a savings account with an APY of 7.0%. You’ll probably find them around 1.0-2.5%. We’re using a higher APY to help demonstrate a point.
How is the interest in my savings account calculated?
The Annual Percentage Yield, or APY, is an interest rate that compounds on a monthly basis.
Since a year is a long time, interest rates are normally broken down into monthly periods.
Imagine if you put your money into a savings account, took it out after 11 months, and the bank didn’t pay any interest since it wasn’t in there for a year.
That would stink! Thus the APYs are actually calculated monthly.
The same example above: Put $100 in a savings account today with a 7.0% APY and in a year you will earn $7.23 in interesting netting you with $107.23 in your savings account.
How is that calculated?
You might think that you would just take $100 times 7% giving you an interest of $7.00 for the year with a total of $107.00.
It would, however, APY takes into account periods, or months, and is thus calculated – or compounded – on a monthly basis.
This chart goes over the math to calculate your interest earned:
- APY: 7.00%
- Initial Amount Saved: $100.00
- Time: 1 Year (12 Months)
- Monthly Rate: 0.58%
The 7.00% interest rate was divided by 12 giving you a monthly rate of 0.58%. The 0.58% was multiplied by the balance of the previous month rounding out to $0.58 interest earned for the first month.
Since this was for a year there are 12 total periods totaling $7.23 in interest earned. Add that to your initial $100.00 deposit to net you with $107.23 in your savings account at years end.
This is the concept of compound interest.
Given the low amount of money in the account it is harder to see but over time you will see more and more interest earned as the monthly balance continues to grow.
What is compound interest?
Compound interest is earning interest on the total amount including the previous interest earned.
APY uses compound interest which is why the amount earned in the previous problem was $7.23 and not $7.00. That’s a good thing!
Did you notice that the interest earned per month increased throughout the year? In the 1st month we earned $0.58 of interest and in the 12th month we earned $0.62 of interest. That’s the result of compounding interest!
We calculated the interest earned by multiplying the monthly interest rate times the total amount in the savings account including the previous interest earned.
That’s why in the 12th month we multiplied $106.61 by 0.58% to get the ending total of $107.23.
It’s An Important Topic To Know
Interest rates, APY, and APR are incredibly important to understand. You can earn or owe a lot of money depending on these rates.
Similarly understanding compounding interest will help you make financial decisions to increase your savings, and ultimately net worth, over the course of 50 years.