What are interest rates and how do they work?
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What is an interest rate?
An interest rate is the cost you’re charged for borrowing money or the payment you receive for depositing or lending money.
You hear about interest rates all the time: An offer for a savings account flashes on your screen with a headline of a 0.4 percent interest rate, or a real estate agent says you might want to buy a house because interest rates are at record lows.
Those interest rates all effectively translate to the price of money. They dictate how much someone will pay to borrow money from you or how much you will pay to borrow it from someone else.
Whether you want to deposit or borrow money, your search should include studying a few key factors to make sure you can get the best deal. One of the most important pieces of the puzzle is the interest rate.
How interest rates work
When you’re earning interest on your deposit accounts, the bank or credit union is paying you. In exchange for those interest payments, the financial institution will put those funds to work by lending it to someone else and charging them interest. The bank will charge a higher rate for that loan. Think of your interest payouts as a sliver of those earnings.
How interest rates are determined
Interest rates on many financial products are tied to benchmark interest rates that serve as governors on economic growth and inflation. In simple terms, lower benchmark interest rates encourage borrowing and spending activity that fuels the economy. Higher benchmark rates help rein in speculative activity that could fuel inflation.
For short-term products like savings accounts and CDs, the federal funds rate plays a central role. The federal funds rate is set by the Federal Reserve, which meets eight times per year to assess the health of the economy and consider any need for changes to interest rates. For longer-term loans and credit products, the rate that the U.S. government pays to borrow money is the key benchmark.
You also play an important role in setting the interest rate if you’re borrowing money. When banks deem you to be a bigger risk as a borrower, the interest rate will increase to account for the institution’s heightened concerns that you could be unable to pay back the loan. If you have a lower credit score or you can only afford to make a tiny down payment, you will pay a higher interest rate than a borrower who has a long and strong credit history with a sizable chunk of cash to put down.
How to earn interest
There is a wide range of banking products that can help you earn interest: a few select checking accounts, savings accounts, money market accounts and CDs. You’re likely to find higher interest rates with accounts that have additional restrictions. For example, you will earn more by locking up your funds in a 3-year CD than you will by depositing them in a checking account that allows unlimited withdrawals.
Regardless of the type of account you want to open, online banks and credit unions tend to offer the most competitive options for earning interest. Without the overhead of physical branch locations, online banks can afford to pay customers more. Online banks are just as safe as brick-and-mortar banks, too. Credit unions, meanwhile, are not-for-profit institutions owned by their members, and they can return profits to members in the form of higher interest rates for savers and lower interest rates for borrowers.
How interest works when you’re borrowing money
When you’re borrowing, the lender gives you an amount of money, and that number — called the principal — accrues interest, which increases the total amount you pay over the life of the loan.
For example, say you borrow $200,000 to buy a home, and the terms include a 4 percent interest rate. Each month, a portion of your payment goes to the principal — that initial $200,000 — while another chunk is one month’s interest that accrues from that 4 percent annual rate. Over the life of a 30-year loan, the interest rate makes a big difference in the overall amount you’ll pay back.
It’s important to note that some interest is fixed, and the rate will never change over the course of the loan. In other cases, the interest is variable, which means your rate will rise or fall with the market.
APR and APY vs. interest rates
Interest rates play a critical role in your finances. However, to get a complete picture of what you’re earning or what you’re paying, you focus on two acronyms: APR and APY.
- APY stands for annualized percentage yield. This number reflects the difference that compounding can make in your ability to earn money from your savings. It’s the interest you earn on your interest, provided that you reinvest it. If you’re comparing savings products, the APY should be your focus with one exception: if you plan to regularly withdraw your interest payments. If you’re retired or living on a fixed income and you plan to use interest as regular income when it arrives in your account, it won’t get the benefit of compounding.
- APR stands for annualized percentage rate. It reflects the total cost of borrowing by including the interest rate and any fees incurred over the term of the loan. There can be a sizable difference, too. For loans with high initial or ongoing costs, the interest rate might be 3.5 percent while the APR could be 4.5 percent. Use that APR as your key comparison point to understand how to make your borrowing experience better for your budget in the big picture.