Understanding the Concept of Interest Rates
Higher interest rates can be a mixed bag. They’re great if you’re talking about your savings or CD account, but not so much when it comes to the interest on your credit card bill. You might have heard about the Federal Reserve raising interest rates, but what exactly are interest rates, and how do they impact your finances?
### What Is an Interest Rate?
Interest rates can be understood in two ways: the interest you pay or the interest you earn. It’s either the cost you incur when borrowing money or the benefit you receive from depositing money. This rate is expressed as a percentage.
### How Do Interest Rates Work?
When you have a deposit account, your bank or credit union pays you money, known as annual percentage yield (APY). On the other hand, when you borrow money, the interest you pay helps fund the interest banks pay on deposit accounts. This creates a cycle of financing where the interest from loans supports other financial activities.
### APY vs. APR
To understand the difference between the interest you earn and the interest you owe, it’s helpful to know what APY and APR mean.
– **Annual Percentage Yield (APY):** This is the rate you earn on deposit accounts like savings, CDs, or money market accounts. It’s calculated annually and includes compound interest.
– **Annual Percentage Rate (APR):** This is the interest you pay on loans or credit accounts, including any fees, and is also calculated yearly.
### Common Areas Where You Earn Interest
Deposit accounts often offer an APY, which can be competitive or higher than other banks or credit unions. Examples include:
– Savings accounts
– High-yield savings accounts
– Certificates of deposit (CDs)
– Money market accounts
– High-yield checking accounts
### Common Areas Where You Pay Interest
When you borrow money or take out a loan, it usually comes with an APR. You’ll pay this rate on top of the loan amount and any associated costs. Common areas include:
– Mortgage interest rates
– Mortgage insurance
– Student loans
– Cash advances
– Credit cards
### Types of Interest
Interest on financial products like loans or savings accounts is calculated using either simple or compound interest. Simple interest is more favorable when borrowing money, while compound interest is better when earning money on savings products.
Interest can also be fixed, staying the same for the loan’s duration, or variable, meaning it can change over time.
#### Simple Interest
Simple interest is often applied to auto, mortgage, and personal loans. It’s calculated using this formula:
\[ \text{Principal balance} \times \text{interest rate} \times \text{term of loan (in years)} \]
For example, if you borrow $14,000 at 12% interest for three years, you’ll pay $5,040 in simple interest. So, you’ll need to pay back a total of $19,040.
#### Compound Interest
Compound interest typically applies to deposit products like savings accounts, money market accounts, and CDs. It’s also commonly used by credit card issuers, compounding interest daily.
Compound interest is calculated at set intervals (daily, monthly, quarterly, semi-annually, or annually). The interest earned is added to the principal, and future interest is calculated on this new balance.
For instance, if you put $15,000 in a three-year CD with a 5% APR that compounds monthly, the total interest earned at maturity would be $2,422.