All about interest

Understanding how interest works can be a great foundation for becoming a more informed money manager. Why? Because rates of interest usually come into play whenever money is lent or borrowed, which may be more often than you think.

So, are you a lender? You may not think of yourself as one, but if you have a bank account, you’re basically lending money to the bank. Do you consider yourself a borrower? Using a credit card is essentially borrowing from a line of credit, a preset amount of money that the card issuer has agreed to lend you.

Whether you’re hoping to maximize returns on a savings account or simply looking to open a new credit card, arming yourself with knowledge about interest can come in handy. Knowing the difference between simple interest and compound interest, for example, may set you up to make better decisions about how you spend, save and borrow.

Simply put, interest is the percentage fee paid when money is borrowed or made when money is lent.¹

Interest earned is like bonus money the bank pays you just for keeping money in an account, such as savings.

Interest owed is the fee you pay when you borrow money, like when you take out a loan. You pay interest to the lender for the privilege of borrowing.

When it comes to interest, it may help to keep this in mind: Keeping money in an account longer will likely earn you more interest.² And paying a loan off ahead of schedule will likely cost you less in the long run.³

Simple interest is money earned only on the original sum of money invested.⁴ Here’s how to calculate interest earned on a savings account: If you put $20,000 in a simple interest savings account at a rate of 1% monthly interest, you’ll earn $200 each month. With a simple interest savings account, you will always be earning 1% of $20,000 even when your balance exceeds the original deposit. That means that even if your balance increases to $20,200 after one month or $20,400 after two months and so on, you will still only be receiving interest on the original balance of $20,000.

Compound interest is the interest earned—not only on the original sum of money—but on the interest you earn as well. With this method, interest can grow exponentially over time, regardless of the initial amount.⁵

You may have heard about "the magic of compound interest" and there’s a good reason for that. Making regular deposits into a savings account, especially if you start early, can have a mighty snowball effect. That’s because compound interest grows at a faster rate than simple interest.

To stick with the example above, if you deposit $20,000 at a monthly compound interest rate of 1%, the first month would earn you $200 (1% of $20,000). But here’s where things get interesting: The second month’s interest earned would be $202 (1% of $20,200) and continues to increase as long as you keep your money in the account.

So what investments offer compound interest? Banks that pay compound interest may do so with offerings such as savings accounts, certificates of deposit (CDs) and money market accounts (MMAs). Some high-interest checking accounts have rates similar to savings accounts, but many pay no interest at all.

If you’re looking to maximize interest, it’s a good idea to research several banks with compound interest savings accounts before you commit to one.

When you take out a loan, you may be offered a fixed rate or a variable rate of interest. Having a fixed rate doesn’t mean it will never change. It means it’s not tied to current market rates, such as the prime rate. That’s different from a variable rate, which could change based on market rates.⁶

Generally, if you can secure a loan at a low fixed interest rate that works within your budget, you may want to go that route so there are no surprises down the road. On the other hand, if interest rates are falling, it may make sense to choose a variable rate loan. As interest rates fall, so will the interest rate on your loan. As they rise, you guessed it, the rate you pay will rise as well.

There are pros and cons to each, so you’ll want to consider your unique situation.

When you’re figuring interest on a savings account, keep in mind that it will be paid every time interest is calculated depending on the agreement you have with your bank. It may be daily, monthly, semiannually or annually.

The more often it’s compounded, the more interest you’ll earn, so daily compounding will net you the most return on your savings. Likewise, annual compounding may be more beneficial if you’re the one who’s paying interest on a loan because the less often it compounds, the less you’ll owe that lender.

APR stands for annual percentage rate and refers to the amount of interest and fees you’ll pay on a loan or credit card balance over the course of a year.⁷ APR includes mandatory fees, so it can be a useful bottom-line number when comparing various lending rates.

APY means Annual Percentage Yield. It’s the interest rate earned or paid over the course of the year with compounding.⁸ If you’re wondering how to find the APY of an investment, you can always ask your banker, review terms on the paperwork or look at your bank’s website.

The U.S. Federal Reserve—the official government bank that oversees U.S. banks—sets interest rates.⁹ "The Fed" has the power to adjust interest rates for banks in order to control the supply of money in the economy. So if the economy is slowing down, the Fed might lower interest rates to encourage people to take out loans and make purchases. If the economy is growing quickly, it might increase rates to prevent inflation, which is what happens when prices rise above the value of goods.

When interest rates are higher, you could earn more money on your deposits, but you also pay higher interest rates on any loans. When interest rates fall, you might earn less money on your savings, but also pay less to borrow money. This is why some people wait for interest rates to fall when they’re getting ready to make a large purchase like a house.

Once you see how it all works, interest can become a lot more, well, interesting. Over time, anyone with a bank account is likely to be a borrower or a lender. And the more you understand how interest can work to your advantage, the better you may become at managing your money. Putting compound interest to work may even help you build a pretty cozy nest egg—with a little less effort along the way.