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What is interest? Your guide to learning APR vs. APY
Get the best deal by knowing the ins and outs of interest rates.
Some types of interest rates cost you money and some earn you money. Some compound interest and others don’t — and then there’s also fixed vs. variable rates to consider. Knowing the terminology before you choose a new card, loan or account can help you make the best decision.
What is interest?
Interest is the extra money you pay for borrowing funds or receive for lending funds. It’s expressed as a percentage and calculated based on the principal balance.
When you borrow, interest is added on to the principal balance and you end up paying back more money than you borrowed. When you lend money out yourself — or put it in a savings account for the bank to lend out — you earn interest because you let someone else use your funds.
What are the different types of interest rates?
There are several different types of interest rates:
- Fixed interest rates. This is a set interest rate that is essentially “locked” for the duration of your loan term. The rate you agree to in your loan contract is guaranteed to remain in place until you close the loan at the end of the term.
- Variable interest rates. This is a rate that may change during your loan term and may be more common in some products than others. For example, personal loans can come with variable interest rates, but it’s unlikely for the rate to change during the loan term. On the other hand, it’s much more likely that a mortgage with a variable rate will change.
- Compound interest. This is calculated based on your current account balance, which includes any interest previously earned. It’s called compound interest because you earn interest on your interest, which makes the sum grow faster. It’s mostly used for bank accounts.
- Simple interest. This form of interest is only calculated on the principal balance. It doesn’t include any interest you’ve already earned. Simple interest is mostly used for car loans.
What’s the difference between APR and APY?
Knowing the meanings of the most common terms you’ll come across when making financial decisions can help you make the most of your money:
- APR. This is the bad kind of interest. APR stand for annual percentage rate, and it’s the amount of interest you have to pay each year. To save the most money, look for loans and credit cards with a low APR.
- APY. This is the good kind of interest. APY stands for annual percentage yield, and it’s the amount of interest that gets paid to you each year. To earn the most money, look for savings accounts and investments with a high APY.
How is interest charged on different financial products?
Interest works differently depending on the type of product you have:
Credit cards
Credit cards come with variable, annual interest rates. The rates vary depending on what features the card offers, but the average card falls somewhere between 15% and 22% APR. If you have excellent credit, you can qualify for a lower rate. If you have a low credit score, expect to pay on the higher end of that spectrum — or more.
There are two types of interest rates on a credit card: purchase rate and cash advance rate. The purchase rate is what you’re charged to make purchases on the card and the cash advance rate is what you’re charged to withdraw cash using the credit card. Credit cards can also offer special interest rates such as introductory 0% rates or balance transfer rates.
Personal loans
Interest rates on personal loans can be fixed or variable and are annual rates. In the past, these rates reflected the market at the time. Recently, however, lenders have been moving towards personalizing interest rates based on how risky it is to offer the loan.
This is why there are now two types of interest rates you’ll see advertised for personal loans: set rates and risk-based rates. Set rates will be given to everyone who is approved for a personal loan by that lender. Lenders offering risk-based interest rates will do so using a range — 7% to 18% APR, for example — and your exact rate will depend on your credit score and job stability. You can typically get a rate estimate before applying for a loan.
Mortgages
Mortgage interest rates can also be fixed or variable. Fixed interest rates are guaranteed not to change, whereas variable rates may fluctuate. Variable interest rates can change quite frequently, as they’re heavily influenced by the economy.
The interest you’re charged will generally be calculated daily. Mortgages can either be principal and interest — meaning you’re repaying both the interest you’re being charged and the original amount you borrowed — or interest-only. With the latter, you’re only repaying the interest accruing on your debt.
Savings accounts
Savings accounts work differently from credit accounts because the interest rates earn you money rather than cost you money. All savings accounts come with a variable base rate, with most calculated daily on your principal balance and paid into your account monthly. This is referred to as compound interest: the interest payments you earn then go on to earn their own interest. Certificates of deposit (CDs) and other savings options work similarly, though CDs offer fixed interest rates.
Back to topHow should I compare interest rates?
Keep the following in mind when comparing interest rates:
- The actual rate. Look at how competitive the interest rate is when comparing. While the cheapest isn’t necessarily the best, a better interest rate can do a lot to save you money in the long run.
- Fees. Check for any fees that the account or loan has, including upfront and ongoing fees. If you find an option with a competitive interest rate but sky-high fees, calculate whether it’s still the best option.
- Apples-to-apples. While comparing interest rates across products is a good idea, make sure the products you’re comparing are similar. For example, you might compare one credit card to another one with a much lower interest rate, but no features.
What is a negative interest rate?
Compare interest rates across loans, credit cards and savings accounts
Bottom line
Before signing any financial agreement, make sure you understand all of its associated terms. Use that knowledge to shop around and find the best deal.
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