How Does Interest Work?

How does interest work? Find out what an interest rate is, how it is set and how it works for different types of loans.

Contents:

  1. How Interest Works
  2. Compound vs. Simple Interest
  3. What is an Interest Rate?
  4. Interest Rate Comparison Video
  5. What are APRs?
  6. How Interest Rates are Set
  7. Loan Types and Interest Rates
  8. Other Considerations

How Interest Works

You’ve heard plenty about interest and interest rates. But what do these terms really mean for you and your finances? We’re breaking down some interesting details about interest so you can make smart decisions about your money and how you want to use it.

Let’s start with the basics. Interest is what you pay to a person or lender in order to borrow money or purchase/lease an asset like a car, home or business. Principal is the amount you are borrowing (or the cost of the asset).

Interest is also the amount you earn on a savings account, money market, savings certificate or other interest-bearing account. You make a deposit to your credit union account and the credit union pays you interest in order to be able to use that money. The longer you keep your money in the account, the more interest you can earn!

Compound vs. Simple Interest

There are two types of interest: simple and compound.

  • Simple interest is a set percentage of the amount that you borrow. For example, if you are charged 10% to borrow $100, you would pay back $110. Most loans from a friend or family member are paid back with simple interest (if any). Some credit union or bank loans also use simple interest.
  • Compound interest takes into account the principal borrowed as well as any interest accrued up until this point. You’re paying interest on the principal, as well as interest on the interest. (As a reminder, the principal is the sum borrowed from the lender, while interest is the additional money paid to the lender for the privilege of borrowing that amount.) Interest can be compounded monthly, quarterly or annually. Loans with a shorter compounding timeframe (daily, monthly) will cost you more in interest if you’re the borrower, but they will also earn you more if you’re saving money in an interest-bearing account!

What is an Interest Rate?

An interest rate is the amount that a lender charges you to borrow money, typically expressed as a percentage. You will also see interest rates advertised on savings and money market accounts, savings certificates, IRAs and other interest-bearing products. This is the percentage that the financial institution will pay you for the temporary use of the money in your accounts.

See how interest can make a big difference to your bottom line.

What are APRs?

You’ll often see the term APR on credit card or loan documents. APR stands for Annual Percentage Rate and includes both interest and any processing fees that you’ll pay to your lender during the year. (Note that APR does NOT include any fees that you may accrue as a result of your actions during the year, such as a returned payment fee or late payment fee.)

How Interest Rates are Set

Lenders determine the interest rate that they will charge on a loan based on factors that include loan type, loan term and the applicant’s credit score and credit history. So, a good rate for one person might not be a competitive rate for another person with a stronger credit history and higher score.

Loan Term

Your loan term indicates how long you have to pay back your loan. A “term loan” means that you have specified payment amounts to be paid back over a set number of months or years. For example, if your loan term is 60 months, you have a total of five years to pay off your loan. If your loan has a fixed interest rate, you will have pre-set monthly payments. If your loan has a variable interest rate, your payment amount may change from month to month.

Credit Score

Your credit score is a three-digit number that lenders can use to assess your creditworthiness and risk level. Credit scores range between 300 and 850. While there are a variety of credit score models out there, a credit score of 700 and up is typically considered a “good” score, while scores of 750 and up are deemed “excellent.” According to data collected by Experian, one of the three major credit reporting agencies, the average credit score in 2020 was 711 — up from 703 the prior year.1

  • High credit score = Low risk
  • Low credit score = High risk

An excellent credit score indicates to the bank that you are a lower risk to them, which means you could potentially qualify for a more favorable interest rate. Need more info? Get a quick video refresher on how credit scores work.

Loan Types

Now that you have the basics of interest down, let’s take a look at some of the popular loan types and how they work.

Mortgage/Home Loan

Buying a home is one of the largest purchases you’ll ever make, so you want to make sure you borrow wisely. As of late 2020, the average price of a home in Arizona was $303,230, up more than 13% from the previous year.2

Because a home is such a large purchase, the terms of a mortgage loan are much longer than most other loans — typical mortgage terms are 15-year, 20-year and 30-year. A down payment is required for nearly all mortgage loans. After peaking at over 16% in the 1980s, the average mortgage interest rate has steadily decreased to record lows around 3-5% within the past few years.

Auto Loan

The average new car costs $34,047, according to data collected from Kelley Blue Book, Edmunds and J.D. Power. The average monthly auto loan payment is $563 for new vehicles in Arizona and $354 for pre-owned rides.3 Common auto loan terms are 60 and 72 months, and a down payment of up to 20% may be required by the lender depending on your credit and other factors.

Credit Cards

Unlike auto and mortgage loans, which have your car or home as collateral, credit card lenders don’t have any property they can take back if you don’t pay. Because the risk to your lender is higher, interest rates on credit cards are typically higher than rates on other loan types.

According to U.S. News & World Report, the average credit card APR ranged from 15.56% to 22.87% as of December 2020, depending on the type of card and the cardholder’s credit.4 The good news is that you only pay interest on balances you carry over from month-to-month. So, if you buy something today and pay your credit card bill off before your next monthly payment is due, you won’t pay interest on that purchase!

Payday Loans

These short-term loans can have mindboggling interest rates in the 300-400% range, earning them a bad reputation among consumers and the lending industry. While payday loans were outlawed in Arizona in 2010, short-term loans charging up to 36% interest are still legal.5 That’s why many financial experts recommend saving a separate emergency fund of $500-$1,000 as a smart alternative to taking out short-term loans.

Other Factors to Consider

When you’re choosing a lender, it’s not just about comparing interest rates. You also want to make sure that you select a lender you can trust — one that is transparent about your loan and how it works. Check rating sites and social media to see how the lender’s members or customers rate their experiences. Get recommendations from friends and family. Additionally, you may want to select a locally based lender so that you can get in touch quickly and easily when you need them.

Increasing your financial know-how is a great way to lay the groundwork for reaching your financial goals. The more you understand how interest works and how it affects you, the better prepared you will be the next time you apply for a loan or put your money in an interest-bearing account.

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1https://www.experian.com/blogs/ask-experian/what-is-the-average-credit-score-in-the-u-s/
2https://www.zillow.com/az/home-values/
3https://www.cnbc.com/2019/12/09/map-shows-the-average-monthly-auto-loan-payment-in-every-state.html
4https://creditcards.usnews.com/articles/average-apr
5https://www.azleg.gov/viewdocument/?docName=https://www.azleg.gov/ars/6/00632.htm

The material presented here is for educational purposes only, and is not intended to be used as financial, investment, or legal advice.