What Is Interest And How Does It Work?

Interest is either the cost of borrowing money or the reward for saving or investing it — depending on which side of the transaction you’re on.

For borrowers, interest is a percentage of the amount of a loan you’ll owe across a year, paid to the lender. This percentage is known as the interest rate on the loan. For investors or savers, interest comes in the form of an annual percentage yield (APY).

For example, a bank will pay you interest when you deposit your money in a high-yield savings account. The bank pays you to hold and use your money to invest in other transactions. Conversely, if you borrow money to pay for a large expense, the lender will charge you interest on top of the amount you borrowed.

Understanding how interest works is essential to making smart financial decisions. In this guide, we’ll break down the basics of interest, how it’s calculated and what it means for your loans, credit cards, savings accounts and more.

How interest works when borrowing

Whenever you borrow money, you’re required to pay the principal (the loan amount) back to your lender. You’ll also need to pay your lender the interest, typically an annual percentage of the principal, set for the loan. These loans come in many forms, including credit cards, student loans, car loans, mortgages and personal loans. Understanding how the interest terms and repayment requirements work is essential to managing debt wisely.

For example, let’s say you borrow $10,000 from your bank in a straightforward loan with a 10% interest rate per year, and the loan is repaid over five years. In this example, you’d pay about $2,748.23 in interest over the life of the loan.

You can use Bankrate’s loan calculator to estimate how much interest you would pay on a loan.

How interest works when saving

You can earn interest in savings products like a high-yield savings account, money market account or certificate of deposit (CD). There are also traditional savings accounts, but they earn much less interest compared to high-yield savings accounts.

Most savings accounts offer compound interest (more on that below). The more you put into savings, the more your savings compound, and the more interest you earn in your account.

Interest vs. APY

If you’re an investor or saver, understanding APYs can help you grow your wealth over time. An APY accounts for both the simple interest rate and the additional interest you earn due to compounding. (Think of compounding as earning interest on your interest.) 

When you open a deposit product, like a savings account or certificate of deposit, the listed APY tells you how much you will earn over a year. An APY makes doing the math to figure out what you’ll earn simple. For example, suppose you have a savings account with an APY of 5%. If you had $10,000 in the account, you’d earn 5% of that amount — $500 — in interest after one year.

How are interest rates determined?

When you borrow money, your financial health and credit history are the main factors determining the rate you get. When you save money, the financial institution sets rates based on economic factors. 

Credit products

With credit products, like a credit card or loan, each lender has a range of possible rates that depend on market conditions. But they use a number of different factors to determine your interest rate within that range, including your credit score and debt-to-income ratio. Lenders use these to evaluate whether they can count on you to repay the amount you borrow. If they think you’re likely to miss payments or fail to repay the loan, they will charge higher interest to make up for that risk.

Depending on the loan product, the range of possible rates can be dramatic. Say you have excellent credit and plenty of room in your budget. You might get a five-year, $30,000 car loan with a fixed 6% interest rate and a $580 monthly payment. But if your credit is poor, you might get a 13% interest rate on the same loan, bring your monthly cost to $683.

Deposit products

With deposit products, like high-yield savings and CDs, interest rates depend less on you and more on the economy: The rates financial institutions advertise change based on market conditions and what competitors are offering. You might get a higher rate for depositing more money or having another account with the same bank, but your personal finances don’t factor in. 

Simple vs. compound interest

For both deposits and credit products, there are two basic methods to calculate interest: Simple interest and compound interest.

For large loans with high interest extended over a long term, the increase in total amount paid when interest is compounded can be significant. For this reason, it’s always important to ask your lender or your bank whether a loan or your savings account will have simple or compound interest.