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.
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.
For savings accounts, the interest rate is probably the most important factor in growing the money you’ve stashed away, and it’s usually expressed as a yearly rate called the annual percentage yield (APY). While many traditional banks and credit unions pay an interest rate somewhere around the national average of 0.09%, there are several others that pay around 2.00% or more. On a $5,000 balance, that’s a difference of $95 each year.
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.
How do variable rates work for savings accounts?
If you open a savings account, the money you deposit will earn interest at a variable rate. This rate is regularly adjusted by your bank in line with fluctuations to the federal funds rate. In other words, the maximum variable rate of interest you can earn will go up and down over time. Over the past decade, inflation has fluctuated from a low of 0.1% in 2015 to a high of 3.2% in 2011.
In some cases, you may find that the interest earned on your account doesn’t match the advertised rate. There are a few reasons this can occur:
Introductory interest rates
There’s the introductory rate that a bank uses to get you in the door, and then there’s the long-term rate applied to your account. Some banks — particularly smaller ones — will temporarily raise their interest rates above the usual level. Then, in a few months, they drop back down.
When opening an account, look at the historical interest rates the bank has offered — major swings can be a red flag.
Karen opens a savings account with a small bank that offers an introductory rate of 3%, but after six months the rate drops down to 1.5%. Josie looks into the historical rates of her bank before opening an account to make sure her interest rate won’t vary too wildly, and her rate of 3% stays the same over the course of the year.
3% for the first six 6 months, 1.5% for the second 6 months
As the table shows, even though Karen and Josie deposited the same amount of money, Karen earned $1,148.92 less because her interest rate changed.
The type of interest rate you have
Another important factor that affects the interest you can earn on your savings balance is whether your account pays simple interest or compound interest. Simple interest is only paid on the money you deposit into your account, but compound interest allows you to earn interest on the initial deposit and the interest payments you receive — in other words, you can earn interest on your interest.
How often interest is compounded
The interest on your account could be compounded daily, monthly, quarterly, biannually or annually, and the frequency with which it occurs can make a surprising difference to your balance. The more interest is compounded, the more chances you have to earn interest on your interest.
Adam is in his early 20s and wants to start saving for a house. He has an initial investment of $5,000 and plans to deposit $500 each month for the next five years. Assuming an interest rate of 5%, let’s look at how Adam’s balance differs based on whether interest is compounded daily, monthly or annually.
Ongoing monthly deposit
Adam can earn more interest by choosing an account that compounds interest daily. In fact, after five years, he ends up with an extra $143.53 compared to an account that compounds interest annually.
The rate of interest you earn on your savings is set by your bank, though interest rates generally fluctuate with the broader financial market and can be influenced by the rates set by the Federal Reserve Bank. Interest rates vary by bank and the type of savings account you choose.
Savings accounts typically accrue daily or monthly compound interest. With daily compound interest, your bank calculates interest on your balance each day using a specified rate. In effect, you end up earning interest on the interest you’ve already earned. Your bank then pays out the compounded interest monthly as a credit to your account.
Your money doesn’t sit in a savings account untouched. When you open an account, you give your bank access to lend your money out to others.
Banks reward you for that access with interest, even if those rates are slightly lower than the rate they charge borrowers. It’s how they stay in business.
And if the bank loses money on that loan, it doesn’t affect your account balance. Furthermore, the vast majority of banks and credit unions are insured by the government, so even if they go out of business, you’ll get up to $250,000 back.
How to get higher interest rates
To get a bump in your savings account APY:
Compare accounts. Both at different banks and even within the same bank. For example, if you meet the monthly minimum, a money market account could net you a higher interest rate than a traditional savings account. If you won’t need to access your money anytime soon, consider opening a CD account.
Consider online and challenger banks. Newer online-only and app-based challenger banks don’t have to deal with the overhead that comes with operating bank branches, and they can pass those savings on to you in the form of better interest rates.
How much difference does a 0.50% or 1.00% increase in APY make?
A percent, or even half a percent, difference can add up to significant savings over time. For example, Rebecca puts $40,000 into a savings account with a 2.50% APY, and she adds $750 each month. After five years, she’s made $8,200.45 in interest.
If she would have opened an account with a 3.00% APY, she would have made $9.949.71 in interest, or about $1,749 more.
If Rebecca’s APY was 3.50%, she would have made $11,737.30 — that’s an extra $3,537 over five years just for choosing an account with an APY that was 1% higher.
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 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.
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.
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 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.
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.
Yes. Borrowers with excellent credit scores are typically eligible for the most competitive interest rates. Some lenders won’t even consider applicants whose scores fall below a certain threshold. Check your credit score before applying for a new credit card or loan.
Elizabeth Barry is Finder's global fintech editor. She has written about finance for over six years and has been featured in a range of publications and media including Seven News, the ABC, Mamamia, Dynamic Business and Financy. Elizabeth has a Bachelor of Communications and a Master of Creative Writing from the University of Technology Sydney. In 2017, she received the Highly Commended award for Best New Journalist at the IT Journalism Awards. Elizabeth's passion is writing about innovations in financial services (which has surprised her more than anyone else).
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