Whether you’re borrowing money from a bank or saving money in a bank account, interest and interest rates will play into your financial picture. And understanding exactly how they work is crucial to making the best possible decisions for your money.
Interest — the money you’re charged for borrowing money or earning for saving money — can make a big difference for your financial future. Here’s the scoop.
Interest Rate Definition
Interest is the money you’re charged when you take out a loan from a bank — or earn for leaving your money in a bank to grow.
Interest is expressed as a percentage of the total amount of the loan or account balance, usually as APR (Annual Percentage Rate) or APY (Annual Percentage Yield). These figures estimate how much of the loan or account balance you could expect to pay or receive over the course of one year.
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How Interest Rates Work
Let’s look at some specific examples.
You might take out a personal loan with an APR of 5.99%. That means you’ll pay an additional 5.99% of the loan balance each year in addition to the principal payments, which is paid to the lender for servicing the loan.
Or, if you hold a high-yield savings account that offers a 1% APY return, you can expect that account to grow by 1% of its balance each year.
Of course, the interest you might earn in a savings account is usually substantially lower than what you might earn on higher-risk investments.
And when it comes to any of the multiple uses of a personal loan, paying interest means you’re paying substantially more than you would if you were able to pay for the expense out of pocket.
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Interest Rates Explained
While all interest does one of two things — accrue as a result of saving money or in payment to the bank for a loan — it can be calculated and assessed in different ways. Here are a few common types of interest rates explained.
Simple Interest
Simple interest is interest that is calculated, simply, based on the balance of your account or loan — as opposed to compound interest, which is based on the principal balance as well as interest accrued over time.
Most mortgages are calculated using simple interest. That means you won’t pay additional interest on any interest charged on the loan.
Compound Interest
Compound interest, on the other hand, means that interest is charged on not only the principal but also whatever interest accrues over the lifetime of that loan.
For example, credit cards are subject to compound interest. If interest charges accrue on a revolving balance, interest will be charged on that interest, making it possible for the debt to accumulate.
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Precomputed Interest
Loans that calculate interest on a pre-computed basis are less common than loans with either simple or compound interest. They’re also controversial and have been banned in some states. Precomputed interest has been banned nationally since 1992 for loans with terms longer than 61 months.
This method of computing interest is also known as the Rule of 78 and was originally based on a 12-month loan. The name is taken from adding up the numbers of the months in a year (or a 12-month loan), the sum of which is 78.
Interest is calculated ahead — precomputed — for each month and added to each month’s payment, giving more weight to interest in the beginning of the loan and tapering off until the end of the loan term. In the case of a 12-month loan, the first month’s interest would be 12/78 of the total interest, the second month’s interest would be 11/78 of the total interest, and so on.
A loan with precomputed interest has a greater effect on someone who plans to pay off their loan early than one who plans to make regular payments over the entire life of the loan.
APR vs APY
Whether compound or simple, interest rates are generally expressed as APR (Annual Percentage Rate) or APY (Annual Percentage Yield). These figures make it easier for borrowers to see what they can expect to pay or earn in interest over the course of an entire year of the loan or interest-bearing account’s lifetime.
However, APY takes compound interest into account, whereas usually APR does not — but on the other hand, APR takes into account various loan fees and other costs, which APY might skip.
| APR (Annual Percentage Rate) | APY (Annual Percentage Yield) |
|---|---|
| Expresses what you pay when you borrow money | Expresses what you earn on an interest-bearing account |
| Factors in base interest rate over the course of one year | Factors in base interest rate over the course of one year |
| Factors in fees and other loan costs | Does not factor in fees and other loan costs |
| Does not factor in compounding | Factors in compounding |
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What Is an Example of an Interest Rate?
Let’s take a look at a specific example of interest and how it can add cost to your loan over time.
Say you take out an unsecured personal loan in the amount of $20,000 to pay for home remodeling. The loan is offered to you at an interest rate of 6.99% compounded monthly, and you must also pay an upfront fee of $500 for the loan. You’ll pay it back over the course of five years.
Over the course of those 60 payments, you’ll pay $3,755.78 in interest, not including the $500 extra you paid in fees. Each month, you’ll pay back some of the principal (the original money you borrowed) as well as the interest charged to you.
By the time you’re done with your home remodel, you’ll have paid $24,255.78 altogether, and that’s on a personal loan with a fairly low rate. In other words, you’ll have paid 20% more for the project than you would have if you’d funded it out of pocket.
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What Is the Difference Between Interest and Interest Rate?
Interest refers to the money itself that is either charged to you or earned by you, the borrower or saver. The interest rate, on the other hand, is the figure by which the amount of interest is expressed.
In order to understand the full impact of your loan’s interest rate — that is, how much interest you could pay over the lifetime of the loan — you should ask for an amortization schedule, which will show the actual dollar figure you can expect to spend over the lifetime of the loan.
How Are Interest Rates Determined?
Each applicant will have different interest rates offered to them based on their financial profile, including the credit reports created by the three credit bureaus as well as their income level, employment history, and more.
Generally speaking, the higher your credit score and income level, the easier it is to qualify for loans with better terms and lower interest rates — which, of course, can make it more difficult for people in lower socioeconomic positions to climb their way out.
Interest Rates and Discrimination
Discriminatory lending has had a long history in the U.S. Before federal laws protecting against discrimination in lending practice, lenders would regularly base credit decisions on factors such as applicant’s race, color, religion, sex, and other group identifiers rather than their creditworthiness.
The practice of “redlining” was begun in the 1930s as a way to restrict federal funding for neighborhoods deemed risky by federal mortgage lenders. It persisted for decades, and the detrimental effects can still be felt today by residents of minority neighborhoods.
Since residents of redlined neighborhoods were excluded from approval for regular mortgage loans, they were forced to look for other financing options, which were often exploitive. If they could not find any lender willing to loan to them, they continued renting, unable to gain equity in homeownership.
The Takeaway
Interest is the amount of money that’s charged on a loan or earned on a savings account.
The amount of interest you’ll pay is usually expressed using percentages, which will be listed as either APR (Annual Percentage Rate) or APY (Annual Percentage Yield) depending on which kind of financial product you’re talking about.
Interest can be simple — with money being charged as a percentage of the principal balance only — or compound, meaning interest will be charged against accrued interest as well. The best way to understand exactly how much you stand to pay in interest over time is to ask to see an amortization schedule.
Considering applying for a personal loan? SoFi Personal Loans offer fixed, competitive interest rates and no fees required. You can check your rate in just one minute online, and it won’t affect your credit score.*
FAQ
What is the definition of interest rate?
An interest rate is expressed as a percentage and is used to calculate how much interest you would pay on a loan in one year (APR), or how much you would earn on an interest-bearing account in one year (APY).
What is an example of an interest rate?
Simple, compound, or precomputed interest rates are types of interest rates commonly used.
What is the difference between interest and interest rate?
Interest is the money you’re charged when you take out a loan from a bank — or earn for leaving your money in a bank to grow.
Photo credit: iStock/Remitski
*Checking Your Rates: To check the rates and terms you may qualify for, SoFi conducts a soft credit pull that will not affect your credit score. However, if you choose a product and continue your application, we will request your full credit report from one or more consumer reporting agencies, which is considered a hard credit pull and may affect your credit.
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