In this article:
- How Does Interest Work?
- Simple vs. Compound Interest
- How Do Lenders Determine Interest Rates?
- Pros and Cons of Paying Interest
- Pros and Cons of Earning Interest
- How to Avoid Interest Charges
Interest is money that may be paid as one of the costs of borrowing on a loan or credit card, or earned from an interest-bearing deposit account or investment.
Understanding how interest works, particularly across different types of accounts, can help you make the most of your savings and investments while minimizing your costs when borrowing money.
How Does Interest Work?
There are three different financial situations where you can pay or earn interest. Here's how they break down.
Borrowing
When you take out a loan or credit card, lenders often charge interest on your balance until you've paid your debt in full.
On a loan, interest will accrue based on your account's interest rate, which may be fixed or variable, and daily balance. Each month, a portion of your payment will pay off the interest that has accrued since your last payment, with the remainder going toward your principal balance (the amount you borrowed).
With a credit card, on the other hand, you can avoid paying interest if you pay your balance in full each month. If you don't pay the full amount, interest will apply to your unpaid charges.
Note that when you're shopping around for a loan or credit card, you'll typically see an annual percentage rate (APR), but that figure factors in both interest and fees, giving you the total cost of borrowing. If there are no extra fees or you have a credit card, the APR is the true interest rate.
Deposits
When you deposit money into a savings account, money market account (MMA) or certificate of deposit (CD), you may earn interest on your balance.
With savings and money market accounts, interest rates are variable and can move up and down depending on market conditions. In contrast, CD rates are typically fixed for the account's term.
Interest rates on deposit accounts are often expressed as an annual percentage yield (APY), which incorporates compounding—more on that in a minute—and gives you a more accurate representation of what you'd earn in a year.
Investing
Certain types of investments, including bonds, offer interest payments to their holders—in this case, you're essentially the lender. Additionally, dividend stocks, real estate investment trusts (REITs) and certain funds could pay income in the form of dividends, which you can reinvest to compound your earnings.
Simple vs. Compound Interest
There are two different ways financial institutions can apply interest. With simple interest, the interest rate is applied only to the principal balance or investment amount. This type of interest is typically used with installment loans and investments.
In contrast, compound interest accrues based on the principal balance and any interest that's accrued since the last payment. Compound interest is commonly used for credit cards and deposit accounts. Additionally, you can earn compound interest on an investment by reinvesting the interest or dividend income you receive.
Examples
To give you an idea of how the two differ in practice, let's say you have a simple-interest loan with a $10,000 balance and a 12% interest rate. Interest would apply only to the $10,000 balance each day—roughly $3.29 per day—until you make a payment and reduce your balance.
With compound interest, let's say you have a $10,000 balance in a savings account and a 4% interest rate. On the first day, the rate would apply to the $10,000 balance, earning you roughly $1.10 in interest. But on the second day, the 4% rate would be applied to a balance of $10,001.10 instead of the principal balance of $10,000.
How Do Lenders Determine Interest Rates?
There are also differences in how interest rates are determined by both lenders and deposit institutions.
Credit Products
There are a few different factors that lenders consider when determining interest rates on credit cards and loans:
- Risk-based pricing: Lenders typically use risk-based pricing, which means that your interest rate is largely determined by your creditworthiness—or the likelihood that you'll pay back the amount borrowed on time. They may also consider your loan repayment term, amount borrowed, collateral, down payment and other elements.
- Market rates: Lenders also typically use a benchmark rate, such as the Wall Street Journal prime rate, to help determine loan rates. The prime rate is directly influenced by the federal funds rate, which the Federal Reserve uses to help control the inflation rate. During times when inflation is high, the Fed hikes its interest rate, making borrowing more expensive.
- Lender policies: Each lender has its own approach to determining interest rates based on its financial profile and strategic objectives. For example, some lenders that specialize in working with borrowers with lower credit scores typically charge higher interest rates compared to lenders with more stringent credit criteria.
Savings Products
Banks and credit unions determine interest rates on their savings products based on a few factors, including:
- Market rates: As with loans and credit cards, the federal funds rate has a direct impact on the rates for many savings products. When inflation is high, you're more likely to find higher rates on high-yield savings accounts, money market accounts and CDs.
- Other economic factors: Financial institutions use consumer deposits to fund loans, so they may also raise interest rates when consumer spending—and, therefore, the demand for consumer loans and credit cards—increases to attract more deposits. If consumer spending is down, banks and credit unions may lower their rates.
- Bank policies: Each financial institution may have its own approach to determining savings rates based on its financial needs, strategic objectives and forecasts. Large banks, for instance, typically don't need to make a lot of effort to drum up business, so they tend to offer lower rates compared to small online banks.
Pros and Cons of Paying Interest
Paying interest isn't always ideal, but there can be some benefits to using credit. That said, there can be some significant drawbacks, especially with high-interest credit products.
Pros
- It allows you to finance large purchases. In an ideal world, no one would need credit to buy a home, a car or other large purchases. But that's not an option for most people. Borrowing money makes it possible for people to obtain housing, transportation and other important things.
- You can leverage your money. If your credit is in great shape and you can qualify for low-interest loans, you can use that opportunity to leverage your money. For example, if you can afford to buy a car with cash, but an auto loan's interest rate is lower than the expected return on a prospective investment, it may make sense to take out the loan and invest the remaining funds.
Cons
- Some credit products are expensive. If your credit score is low, you may have a hard time qualifying for low interest rates. The higher the rate, the more pressure your monthly payment will put on your budget. Even if you have great credit, interest rates can vary depending on the product you choose. Credit cards and unsecured personal loans often charge higher interest rates than secured products like auto and mortgage loans.
- Interest can cause your balance to increase. Making low monthly payments on an account that has a high balance and high interest could cause your loan balance to actually increase over time instead of decrease. This can happen when you're on an income-driven repayment plan for federal student loans, for example.
Pros and Cons of Earning Interest
Putting money in a savings or investment account can help you generate a return on your balance, but it isn't always the most effective way to use your cash.
Pros
- You can earn passive income. Whether it's a savings account or an investment, you typically don't have to do anything to earn interest beyond your initial deposit or investment. The more you save and invest, the more you'll likely earn.
- You could generate returns in other ways. When investing in income-producing securities, such as dividend stocks, REITs and funds, you may also be able to generate gains through price appreciation.
Cons
- Not all opportunities are created equal. Maximizing your interest income can take a lot of time and research. In some cases, it can also be inconvenient. For example, you may need to switch your banking to a new financial institution or even maintain multiple accounts with separate banks.
- Some options carry risks. If you want to maximize your interest income, you may need to lock up your funds with a CD or take on investment risks with an income-producing security. In some cases, you could even lose some of your principal investment.
How to Avoid Interest Charges
The best way to avoid paying interest entirely is to never borrow money. But that's not feasible for many people, so it's important to know how to minimize your interest costs. Here are some steps you can take:
- Establish good credit. Higher credit scores typically correlate with lower interest rates. Check your credit score and credit report to see where you stand. If your score needs some work, look for opportunities to improve your credit, such as paying down high debt balances and bringing past-due accounts up to date.
- Avoid unnecessary credit. Try to avoid borrowing money unless you absolutely need to. If you have some upcoming expenses, such as a vacation, wedding or home improvements, try to save as much as possible to minimize borrowing.
- Avoid overborrowing. In situations where you plan to borrow, take steps to minimize the amount of your loan. For example, if you're buying a home, a large down payment reduces how much of the purchase you have to finance and, therefore, your total interest charges. Also, consider picking a more modest home or vehicle if you're planning to finance that purchase so it doesn't put too much strain on your budget.
- Opt for shorter loan terms. If you can afford it, try to stick to shorter loan terms. While a longer repayment term can reduce your monthly payments, it also typically means paying more in interest by the time the loan is paid off.
- Pay your credit cards in full. If you have a credit card, you can avoid interest by always paying your monthly bill on time and in full during your grace period. Also, avoid cash advances, which start accruing interest immediately.
Frequently Asked Questions
Lenders typically determine interest rates based on economic conditions, market interest rates, the lender's policies and your creditworthiness.
Deferred interest promotions allow you to finance a purchase over a set period of time. If you pay off the purchase during the promotional period, you won't pay interest. However, if you fail to repay the full amount, you'll be charged interest retroactively from the date of the purchase.
While you typically only pay or receive interest in set intervals—usually monthly, quarterly or semi-annually—interest often accrues on a daily basis. The accrued interest adds up until you're due to make or receive a payment. At that point, it becomes regular interest.
Monitor Your Credit to Maintain Low Interest Rates
Building credit is crucial to helping you qualify for favorable interest rates. But once you reach a good level with your credit score, it's important to avoid getting complacent. Otherwise, you could miss some problems that can wreak havoc on your credit history.
The good news is that you don't necessarily have to check your credit score and report constantly to stay on top of your credit. Experian's free credit monitoring service offers alerts when new information, such as inquiries, new accounts and personal information, gets added to your credit report.
As you stay on top of your credit through alerts and checking occasionally, you'll be in a better position to maintain the result of all of your hard work.
