“Interest” is a term we hear left and right. After all, just about every aspect of our financial lives is affected by interest rates. But what exactly is interest? How are interest rates determined and what effect can a high or low rate have on our financial futures?
To get a better understanding of this all-important financial practice, we compiled answers to your interest-related questions.
What Is Interest?
Interest is something that is either paid, or something that is earned.
On a loan, interest is the amount of money charged by a lender for borrowing their funds. Think of it as a fee for having access to a large sum of money earlier than you would have otherwise. Loan interest is expressed as a percentage of the amount borrowed; a number known as interest rate.
On a deposit account, interest is the amount of money you earn for having your funds on deposit. Interest on deposit accounts is known as the annual percentage yield.
What’s the Difference Between Simple and Compound Interest?
There are two types of interest: simple and compound. Simple interest affixes a set interest rate only on the principal amount of money borrowed or deposited. Compound interest, however, applies interest to the principal amount as well as any interest previously accrued.
Let’s take a look at an example to see the difference in action:
Let’s say you deposit $100 in an account with a 5% annual interest rate. In one year, your balance would be $105 regardless of whether simple or compound interest is applied ($100 in principal plus the $5 you earned in interest). After the first year, however, the two interest types diverge. With simple interest, the 5% would continue to be applied only to the $100 going forward, meaning you’d have $110 in two years.
If, however, compound interest is applied to your account, the 5% is applied to the full balance of $105, so you’d have $110.25. Over time, and depending on the account balance, compound interest can accumulate significantly more money.
The U.S. Securities and Exchange Commission’s website has a helpful compound interest calculator to see just how much money you can earn over the years.
How Are Interest Rates Determined?
The Federal Reserve sets the interest rate banks charge each other to borrow money, a number known as the fed funds rate. Financial institutions use this to formulate the interest rates they charge or offer customers.
If interest rates are low, it’s a good time to take out a car loan or mortgage. If interest rates are high, on the other hand, it could be an ideal time to deposit money into a money market account or open a certificate of deposit.
What Affects Your Interest Rates?
Financial institutions use the fed funds rate as a guideline but will usually offer customers varying interest rates. You’ll want the lowest interest rate possible when you’re taking out a loan. This way, you’ll owe the least amount of money over the lifetime of the loan.
The rate a financial institution charges you is indicative of how likely it feels you’ll be able to pay back the money. (The higher the interest rate, the lower the likelihood.) It determines the interest rates it awards through a number of factors. These include your credit score, credit history, loan type, loan term and down payment.
Can Consumers Earn Interest?
Yes! Interest is most often associated with borrowing money from financial institutions in the form of mortgages, car loans, student loans, etc. This forces debt owners to pay interest. But consumers can lend financial institutions money by depositing funds into a savings account or product such as a certificate of deposit. Such financial tools also come attached with interest rates that will grow the account balance and earn their owners money. Granted, interest rates on savings products will always be lower than on loans (the difference is how banks make money) but these accounts are an easy way to watch your money grow on its own.
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