As a consumer, interest rates are a foundational part of your personal finances. You’re either paying interest on a mortgage or car loan, or collecting it through savings and checking accounts or other investments.
Interest is a pretty simple concept, but it can take some time to wrap your head around how to use it to your advantage. Having a good understanding of how interest works will put you in a position to collect the most interest possible while paying the least, whether it’s on a mortgage, car loan or credit card.
Here’s how interest works:
- Let’s get started with a definition.
Interest is the amount of money someone is paying for the use of a sum of money. In the case of a mortgage or car loan, the borrower is paying for use of a financial institution’s money. It’s expressed as a percentage of the sum of money and usually calculated on an annual basis.
Quick example: 5% annual interest on $100 will yield $5 at the end of the year.
- What’s their purpose?
Money is an asset and interest is the cost of using money that isn’t yours. Both financial institutions and consumers benefit. Financial institutions charge more in interest on loans than they pay out for deposits. That difference is their income. For consumers, interest provides access to money for big-ticket purchases, like a home or a car, and income from financial accounts and investments.
- How are they set?
Interest rate levels stem from policy set by the Federal Reserve Bank. Its control of the nation’s money supply acts as a lever to raise or lower interest rates. How much financial institutions charge or pay in interest is influenced by Fed policy and other factors including competition in the marketplace and inflation.
- What’s compound interest?
Simple interest is calculated on the principal only. A simple interest rate of 3% will earn you $30 for every $1,000 invested. Compound interest is calculated on the principal and the accumulated interest. The interest is compounded on a set timeframe, whether that’s daily, monthly or annually. On the above example, 3% interest compounded daily would deliver a gain of $30.40 in interest in a year. It might not sound like a big deal, but compound interest has its biggest impact over longer time spans.
As a saver, compound interest works in your favor. As a borrower, you’ll face higher interest payments. Consumer loans, however, are generally calculated with simple interest.
- APR? APY? What do they mean?
You’ll see these letters a lot if you’re shopping around for loans or places to put your money. They stand for “annual percentage rate” and “annual percentage yield.” APR is a term you’ll see on loans or credit cards, while APY is associated with savings. Both provide a better measure of what you’ll pay or receive in interest than a simple interest rate.
APR is the cost you’ll pay each year to borrow money, including fees, expressed as a percentage. For example, for mortgages, the APR considers other costs associated with borrowing money outside the principal sum. A mortgage APR folds closing costs and other fees into the cost of the loan. Federal law requires that the APR be stated for every loan.
APY is the effective annual rate earned on an account, based on compounding of interest paid at the stated interest rate. For example, 5% interest compounded daily yields an APY of 5.127%.
- Good habits pay off.
How much you pay in interest for loans can depend on your credit score. Lenders take risk into account when setting loan rates. Low-risk borrowers reap the benefits.
Now that you’ve got the rundown on interest, it’s time to start using it in your favor. Check out how you can save more with OCCU interest-earning accounts, or how you can pay less over the long term with our low rates on car loans and mortgages.