Anyone who has ever opened a credit card, taken out a mortgage, or applied for a personal loan is probably familiar with the idea of interest. Even if you don’t know it by name, most people have experience with interest.
In the financial industry, the concept is explained with terms like APR, APY, and fixed versus variable rates. But once you strip away all of that fancy jargon, what is interest? That’s what we’re here to talk about in great detail!
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What is an interest rate?
Interest is the price you pay in exchange for borrowing money from a lender, whether that be a bank or a credit card company. Typically, when you take out a loan, you repay your creditor over time in monthly installments, plus an extra fee. That fee interest.
But there’s no one-size-fits-all fee that you’ll pay. The fee is determined by your interest rate. Most lenders will calculate your interest rate as a percentage of the amount that you borrow based on your creditworthiness, type of loan, and market rates.
For instance, if you borrow a one-year loan of $1,000 at 5% interest, you’ll pay $50 in interest that year. That said, if you take out a multi-year loan or make transactions on a credit card, you might pay something that is called compound interest.
Simple vs compound interest: what’s the difference?
Banks usually charge one of two major types of interest on loans. There’s simple interest and then there’s compound interest. But how do these two types of interest differ? Let’s explore the differences.
What is simple interest?
Simple interest is a flat interest rate based on your principal, or the amount you borrow, with no fancy bells or whistles. Simple interest is generally used on short-term loans.
To give an example, let’s say that you buy a $1,000 laptop at 10% interest. At the end of the first year, you’d owe $1,100 in total, which comprises both your $1,000 principal and $100 in interest.
But if you let your loan roll over for another year, you’d owe $1,200 total. This is because you’d pay an additional $100 in interest.
What is compound interest?
Compound interest is a little more complicated. Essentially, compounding allows lenders to charge interest on top of interest. While this works out well for the lender, falling behind on compound interest loans might make it difficult to repay your debt.
Let’s look at an example. Say that you take out a $1,000 personal loan at 10% interest compounded annually. At the end of the year, you’d owe $100 in interest on top of your principal, which is a total of $1,100.
Now let’s say that you lose your job and you can’t pay back your loan, leaving your interest to pile up. But because your interest is compounding, you won’t just pay interest on your principal in the second year.
You’ll actually have to pay 10% interest on the full $1,100 balance, or an additional $110. At the end of the day, your loan will amount to a total of $1,210.
This illustration highlights how compound interest adds up over time. But we’ve kept things simple for the sake of explaining the difference between interest types. In the real world, your interest may compound more frequently, such as quarterly, monthly, or even daily.
APR vs APY
Depending on the type of loan you take out, you might see interest expressed as an annual percentage rate (APR) or an annual percentage yield (APY). While both terms refer to interest on a loan, they’re not one and the same.
APY is a percentage that reflects the interest earned on a loan within a year. Because it accounts for compounding, it’s often referred to as your effective interest rate. You may see APY listed on your savings account or if you buy government bonds and CDs.
APR is a flat percentage rate that tells you how much you’ll pay in a year without accounting for compounding. However, it does usually consider extra fees, such as origination fees. Typically, you’ll see APR listed on personal loans, auto loans, mortgages, and credit cards.
Owing interest in everyday life
Almost any time you apply for a loan, you’ll pay interest. Here are a few examples of interest that you might be familiar with already.
Credit card interest
Credit cards let you borrow money from a revolving credit line. In fact, CreditCards.com reports that the average APR on a new card hovers around 16% or so. If you pay off your credit card debt within the same month of using your credit card to make a purchase, you usually won’t owe interest.
But if you let your balance rollover, you’ll automatically be charged interest. Some cards add interest daily, which means you’ll start accruing interest when your transaction clears.
A mortgage is a loan that you use to buy a house. Unlike other loans, your monthly payment factors in interest from the start.
In 2021, the average 30-year fixed mortgage rate currently hovers around 2.8% to 3% according to the Federal Reserve bank of St. Louis. But the specific rate that you can expect to pay will depend on factors such as your creditworthiness, income, down payment, and current market rates.
Personal loans are unsecured loans that you can borrow from a bank or an online lender. Unlike other types of loans, like student loans or auto loans, a personal loan can be used for almost anything.
But because you’re not using your home or car as collateral, you can expect to pay higher interest rates. In fact, according to Bankrate, personal loan rates in 2021 are currently anywhere from 3% to 36% on average.
What affects your interest rates?
Your interest rate depends on the terms of your loan. Some of the factors that influence your interest rate can include:
- Your credit score
- The amount of money you borrow
- The type of loan you take out
- Current market rates
- Your down payment if you buy a home or a car
- The length of your loan repayment period
- The lender’s policies like higher rates from bad credit lenders
Earning interest on your accounts
Another place you can benefit from compound interest is with a fully-managed investment account from MoneyLion. Not only that, but you’ll enjoy zero management fees or minimum balance requirements.
You’ll also have access to personalized portfolios and thematic investing opportunities. All you need is a RoarMoneySM account!
Additionally, if you take out a competitive rate installment loan with your $19.99 per month MoneyLion Credit Builder Plus membership, the money saved in your Credit Reserve Account will earn even more interest. And once your loan is paid off, you can invest that interest into your portfolio to earn interest on top of your interest.
If you’re curious about our Credit Builder Plus membership, know that it comes with tons of other perks, too. For instance, you’ll have the ability to boost your credit score by as many as 60 points in 60 days. The membership also includes Lion’s Share rewards and refunds on RoarMoney account fees.
Take charge of your financial future with MoneyLion!
Understanding what interest is and how it works are the first two steps to becoming a responsible consumer. While compound interest can dig you into a deeper hole if you’re not careful, you can also use it to your advantage when you invest.
If you’re ready to take control of your finances, it’s time to get started with MoneyLion. While you may be familiar with our Credit Builder Plus membership, did you know that we now offer a financial safety net feature as part of our one-stop financial shop?
That’s right. With MoneyLion’s Safety Net feature, your banking account works for you, and you’ll reap the benefits of perks like:
- Early direct deposit with a RoarMoney account
- Up to $1,000 in 0% APR Instacash advances with two recurring direct deposits
- A fully-managed investment portfolio
- Round-up options to invest your spare change
- And so much more!