How interest works

Published on Jul 01, 2021

How interest works

You see interest rates plastered on ads everywhere – but do you know how you can benefit from those rates? Interest is a basic financial concept, but many people don’t have a full understanding of how it works.

In short, interest is the amount someone pays to borrow money. It’s calculated as a percent of the overall amount borrowed and is usually reported as an annual percentage yield (APY).  There are several factors that affect how much interest you ultimately pay on a loan and we’ve identified some of them below.    

Two types of savings interest  

Not everyone realizes that interest falls into two different categories – simple and compound.  Each type of interest is different and can have a significant effect on the total amount of interest accrued. 

Simple interest:

Typically used in short-term personal loans; however, it may be used for a savings account. The interest is determined by multiplying the principal balance with the interest rate and an amount of time.

  • Example: If you borrow $1,000 with a 5% APY and a 2-year loan term, you would use the following calculation to determine your total interest $1,000 x 0.05 x 2 = $100. The total amount paid at the end of the term would be $1,100.

Compound interest:

More complicated calculation that produces interest on top of any previously earned interest, thus ‘compounding’ it. Most interest-bearing accounts use compound interest. 

  • Example: If you deposit $1,000 into an account with an APY of 5%, assuming interest is compounded daily, at the end of 2 years you will have $1,105.16 in your account. The same terms calculated via simple interest would give you a total account balance of $1,100.While this may not seem significant, consider that the longer you leave interest in this account, the more it will compound and grow.

How interest affects loans

Interest rates are typically determined through a calculation that leverages the Federal Funds Rate (the rate that banks use to lend to one another) and the Prime Rate (the rate that banks use for the ideal customer with a solid credit rating). 

Rates can change daily depending on the market for loans, the health of the economy, and governmental monetary policy.  The lower the interest rate, the more advantageous it is for the borrower.  The higher the rate, the better it is for the lender.

The amount of time that has been agreed upon for the repayment of a loan can impact the amount of interest paid by the borrower.  In general, the longer the term of the loan, the higher the interest rate will be.  A higher interest rate paired with more time results in more interest being paid throughout the life of the loan.