Interest can be a powerful tool that can help you build wealth. Did you know that there are different types of interest? Understanding how interest works and how it’s calculated can help you make smarter decisions as both a borrower and a consumer.
Read on for a crash course on the different types of interest. We’ll also introduce you to some of the most common interest terms you’ll see when shopping for a loan and explain how you can maximize the interest you earn on the money in your account.
Overview: Interest Rate
Interest is what you pay in exchange for borrowing money from a lender. You borrow money from a bank or other type of lender when you take out a loan or put money on a credit card. In exchange for giving you money, the lender allows you to pay back what you owe in small increments along with an extra charge each month. The extra money you pay is interest.
There are a few different ways that banks can calculate interest. The term “interest rate” refers to how much money you’ll pay per year on your loan. Most banks calculate your interest rate as a percentage of the amount that you borrow.
For example, if you borrow $1,000 with a 4% interest rate, you’ll pay $1,040 dollars back and the lender makes $40 in profit.
The specific amount of interest that you’ll pay depends on a long list of factors. Some of the factors that can affect your interest rate include the type of loan you have, your credit score and the current state of the economy.
Simple Interest vs Compounding Interest: What’s the Difference?
There are two major types of interest: simple and compound. The type of interest you’ll pay depends on which type of loan you take out.
As its name suggests, simple interest is the most basic type of interest calculation. There are two basic components of every loan: your principal (the amount that you borrow) and interest. With a simple interest loan, you only pay interest as a percentage of the principal. Simple interest calculations are usually only used for loans that expire in a year or less.
Let’s look at an example. Say you wanted to buy a used car for $2,000. You go to the bank and your lender offers you a simple interest loan with a 5% interest rate. At the end of the first year, you would owe a total of $2,100 — $2,000 in principal plus $100. If you made no payments on your loan and let your total principal roll over for another year, you’d owe $2,200. That’s $2,000 in principal and $100 per year in interest for two years.
Compounding interest is a little more complicated. Put simply, compounding interest is interest that’s earned on top of the interest you’ve earned in the past. Compounding interest can make it very difficult to pay back a loan if you fall behind on payments, so it’s a good idea to use these loans wisely. Let’s look at an example.
Say you put $1,000 on a credit card with a 10% compounding interest rate per year. Ten percent of $1,000 is $100 a year, which means that your credit card balance would accrue about $8.33 per month in interest. At the end of the first month, you’d owe the credit card company $1,008.33 — $1,000 in principal and $8.33 in interest. With a simple interest rate, you’d owe $1,016.66 at the end of the second month.
However, because you have a compounding interest rate, you’d pay interest on the $8.33 you accrued in interest during the last month. Now, instead of paying 10% of $1,000 per year, you’re paying 10% of $1,008.33 per year. Your total payment due for the next month would be $1,016.73. This cycle will repeat itself every month until you make a payment.
In this example, the difference between a month’s worth of simple and compounding interest is only a few cents. However, as your loan and interest rates get higher, compounding interest can quickly add up and become a financial nightmare. Your interest may compound monthly, yearly, daily or quarterly, depending on your lender.
APR vs. APY
You may see interest expressed as either an annual percentage rate (APR) or annual percentage yield (APY). Both APR and APY describe the interest paid or earned on a loan. However, APY takes compounding interest into consideration, while APR is a flat percentage rate. For this reason, APY is often called the “effective rate” of interest because it includes your compounding interest. In other words, APR tells you what you pay on a loan, while APY tells you what you earn.
You’ll almost always see your interest rate listed as an APR If you want to take out a loan or put money on a credit card. This is because APYs don’t take extra payments you make into account when calculating interest. You may see your interest listed in terms of APY if you buy a locked government bond or CD.
When You Owe Interest
You’ll owe interest almost any time you take out a loan or use credit. Here are some of the most common types of loans that people pay interest.
A credit card company allows you to borrow money to pay for your purchase when you put money on a credit card. You may not need to pay interest on your purchases if you pay off your balance before the end of the month. However, the credit card provider will automatically add your interest to your balance owed if you let your balance stay on the card for more than a month. Some credit card companies add interest to your account on a daily basis. The average credit card interest rate is about 15% APR.
A mortgage is a loan that you use to buy a house. The specific mortgage rate you’ll pay depends on a number of factors, including your income, down payment and current market rates. You’ll make a monthly payment that includes both your interest and principal when you take out a mortgage.
Your monthly payment won’t drastically change over the course of your loan unless you make an extra payment or miss one. Your interest rate won’t change either unless you opt for an adjustable rate mortgage (ARM). An ARM is a home loan with an interest rate that can change periodically.
Personal loans are another type of loan that you can borrow from a bank or online lender. Unlike other types of loans (like student loans and mortgages), you can use a personal loan for almost anything. Personal loans are unsecured loans — unlike a mortgage or an auto loan, there’s no collateral tied to the loan. In other words, a lender can’t repossess your home or car if you stop making payments. You can expect to pay more interest on a personal loan than you will on a secured loan.
Factors that Affect Interest Owed
The amount that you’ll pay in interest depends on the terms of your loan. Some of the most common factors that influence what interest rate you’ll pay include:
- The type of loan you’re taking out
- Your down payment (if you’re buying a home or car)
- How long you plan on taking out your loan for
- Your credit score
- The amount of money that you’re borrowing
- The lender you’re working with
The only way to tell specifically how much interest you’ll accrue is to read the terms of your loan. Ask your lender about your interest rate and what’s influencing it before you accept a loan.
When You Earn Interest
Banks aren’t the only ones who collect interest! You may also earn interest yourself if you hold your money in a bank account. Savings accounts earn interest because when you put money in a savings account, you essentially loan money to the bank. This system allows the bank to give your money to other customers in the form of loans and to offer you a piece of the profit through interest.
You can also earn interest by purchasing CDs (certificates of deposit). A CD is a special type of savings account that loans your money to the federal government. Unlike a standard savings account, you cannot withdraw your money from a CD at will. Instead, you agree to “lock” your money into the CD for a certain amount of time, usually between three and five years. You’ll earn more money in compounding interest through a CD than you would in a standard checking account.
Factors that Affect Interest Earned
Unfortunately, you won’t have much control over how much interest you earn on the money you loan out. You can maximize your interest in a few ways:
- Shop around for banks that the best rates
- Leave your money in a CD for a longer period of time
- Invest more money in your savings account
Understanding Your Interest
Understanding interest and how interest accrues is the first step to becoming a responsible consumer. You might be overpaying on your current loan or credit card — and not even know it!
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