 ## How Do Interest Rates Work?

How Does Interest Work?

Interest is the money “earned” through the lending of money. For a consumer, interest can be looked at in two ways: Incoming and outgoing; the money you make or the money you pay.

First, interest is the compensation a financial institution earns for loaning money to consumers. Because you are using the money that the bank loans you, the bank must be paid for that service. This is usually expressed as a percentage of the loaned money, or an interest rate. The existence of interest allows borrowers to spend money immediately, instead of waiting to save the money to make a purchase.

The second way to look at interest applies if you deposit your money with a financial institution to save it. The financial institution gains the use of that money for investments. In exchange for the use of your money, the institution rewards you with interest.

How do interest rates work?

An interest rate is the percentage of interest applied to a loan or debt. For example, an interest rate of 5% means that the lender is charging you 5% of the principal amount to loan you the money. However, there many different ways of calculating interest, so a simple percentage can be misleading.

Different interest rates are applied to different types of loan products. For instance, credit cards and other forms of unsecured debt (that is, loans that do not use collateral to secure the loan) are generally assigned the highest interest rates. Secured loans, like home mortgages and automobile loans, generally have lower interest rates. This is because the loan is secured by the property used as collateral, and if the borrower stops paying, or defaults, on the loan, the lending institution can repossess the collateral and thus minimize its losses.

How Does Simple Interest Work?

Simple interest is the most basic form of interest rate. It is charged only on the amount of the loan itself, or principal, and is expressed as a percentage multiplied by the term of the loan. For instance, if you received a loan of \$1,000 for a term of 5 years, at a simple interest rate of 5%, you would pay back \$1,250 over the life of the loan. Expressed as an equation, it looks like this:

Loan amount (principal) x Interest rate x Term of the loan (years) = Total amount repaid

You are essentially being charged \$50 per year (5% of \$1000) and multiplying that over the 5-year term.

Most financial institutions, however, do not use simple interest to loan money. Instead, most use a method called Compound Interest.

How Does Compound Interest Work?

Compound interest is the most common form of interest used in lending money. Put in its simplest terms, compound interest charges a percentage of the principal of the loan, plus the same percentage on the interest already accumulated on the loan.

Compound interest can be expressed as an equation, but it is rather complicated: How Does Interest Work on a Loan?

Most loans use compound interest. Let’s say you have an auto loan for \$10,000, for five years, at 5% interest, compounded annually. At the end of each compounding period, in this case, each year, interest is charged on the unpaid principal balance of the loan, and any interest charged previously. In the first year of the loan, that amount is \$10,000. But in the second year of the loan, the amount is larger— because interest will have been charged. In this case, in the second year of the loan, if none of the principal has been repaid, 5% interest will be charged on \$10,500 (\$10,000 + \$500 interest charged in the first year). Therefore, the interest charged in year two would be \$525 (5% of \$10,500). Then in year three, 5% will be charged on \$11,025 (\$10,500 + \$525), and so on. Of course, in this example because we did not account for any car payments made over the year reducing the amount that is outstanding, the example car loan continuously gets larger.

Payments made to loans cause the amount of the loan to fluctuate. This is what can be confusing for many consumers. Payments made on a loan that do not adequately cover the compounded interest of the loan, cause the loan balance to go up over time instead of down. The payments made on a loan early in its term are primarily paying the interest accrued on the loan because the principal amount is greatest at loan acquisition.

How Does Credit Card Interest Work?

Credit cards are a form of revolving debt, meaning you can borrow up to your credit limit and make periodic payments on the debt, which is subject to an interest rate and specific repayment terms. As you repay what you have borrowed, that amount becomes available for you to borrow again.

The most common form of revolving debt is a credit card. For example, you have a card with a \$5,000 limit and you can use that credit to make purchases up to the limit. You will then be charged interest according to a pre-determined rate. The interest charged is usually called a finance charge. Finance charges also include other fees from the financial institution. As noted previously, that interest is compounded monthly in most cases, so if you carry a balance from month to month, you will be paying interest on the entire balance you are carrying—including any unpaid interest accumulated.

Credit card interest rates are typically variable interest rates, which means the interest rates adjust based on the Prime Rate, plus a percentage that is determined by the financial institution issuing the credit card. The Prime Rate is the interest rate charged by the majority of top commercial banks in the United States and tends to move closely in line with market interest rates.

Most credit cards allow you to carry a balance and only make minimum payments each month— generally 1% to 3% of your total balance. However, making payments of more than the minimum due is a good practice, as more money will be going towards your balance. Inside credit card statements, there will be a disclosure explaining how long it will take to pay off the credit card using only the minimum payment, alongside the suggested credit card payments required to pay off the credit card in three years. This can be extremely valuable when deciding your credit card payment amounts.

What is Annual Percentage Rate (APR)?

The annual percentage rate, or APR, is the interest rate charged to a particular credit card or loan product expressed as a yearly percentage. In the case of a credit card, the rate is divided by 12, because the interest is charged and compounded on a monthly basis. For instance, if you have a card with a 12% APR (let’s keep it simple), you would be charged 1% each month.

If you pay off as much as you have borrowed each month, you would be charged a flat 12% on the amount you purchased on the card for the year. If, however, you carry a balance from month to month, that APR will be charged to the entire principal plus interest accumulated—which means you’ll be paying a higher percentage on the amount you use than the APR. This higher percentage is called the annual percentage yield, or APY. The only difference between the two is that APR does not take compounding interest into account, while APY does.

It is important for you to understand the distinction between APR and APY when comparing credit card rates and other financial products.