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Interest 101: How to Understand It, Why It Matters, How to Maximize It

Taylor Moore

Taylor Moore

Finance & Insurance Writer

6 min. read

You likely have memories of sitting in middle school math class and learning the formula for interest: [A = P (1 + rt)]. Depending on your attitude toward math, you may have even thought, “When would I ever need to use this?” 

It’s an understandable thought, as grade school bombards you with concepts you might never use in your practical adult life. But unlike the Pythagorean theorem, the concept of interest applies to anyone who has money and wants to make the best use out of it. With minimal effort on your part, interest can help you build real wealth.

Below, we’ll break down what interest is, the different types of interest and how they will manifest in your financial life, and ways you can take advantage of interest and make it work for you.

What is Interest? 

Interest is the charge you pay for borrowing money from a lender. It’s typically expressed as a percentage, and there are two main types: simple and compound (more on that later). You will often see interest rates referred to APY or APR, depending on what kind of account you’re opening or loan you’re trying to take out. 

You can either earn interest or own interest, depending on whether you’re the lender or borrower. 

If you’ve opened a savings account or other deposit account with a bank, you are a lender. When you put money into a bank account, the bank is essentially borrowing your money in order to carry on its other services, for you and everyone else who uses that bank. In return for using your funds, you earn interest (meaning the bank actually pays you for housing your money with them). 

If you’ve taken out a loan or mortgage, you are a borrower. The bank or another institution has lent you money, and in exchange, you pay them interest for the privilege of using their money, in addition to paying back the principal (the amount borrowed and owed) over time.
If you are a credit card user, you are a borrower. If you roll over a balance from month to month, the credit card company automatically charges you interest on that balance. This is often between 15% and 25% interest per month.

Your interest rate will depend on a number of factors, including:

  • The type of loan 
  • Loan amount
  • Length of term
  • The current state of the economy
  • Your credit score
  • Your credit history
  • Competition in the market

APY vs. APR

In the wild, interest rates are often expressed as either APY or APR. While they certainly sound similar, they are specific types of interest rates used in different situations and are not interchangeable.

APY (annual percentage yield) is associated with earnings on deposit accounts, such as savings accounts and CDs. If you deposit money at the bank and earn interest in return, that is APY. The difference between APY and a standard interest rate is that APY factors in interest that compounds, or accumulates, over one year —  and if that interest compounds more than once annually (say, on a daily basis), your effective return rate would actually be higher than the stated interest rate. This means you want the APY to be as high as possible in order to receive the best returns on your savings.

APR (annual percentage rate) is used most often when you’re taking out loans, such as credit cards, mortgages, and car payments. APR does not take compounding interest into account, so it really understates the amount of interest you’ll have to pay back on a loan — a move that is beneficial for lenders (like car salesmen) and not borrowers. This means you want the APR on your loan to be as low as possible, so you’re not spending significantly more on the privilege of borrowing than you need to.

 APYAPR
What it stands forAnnual percentage yieldAnnual percentage rate
What it meansInterest earned on a loanInterest paid on a loan
What it's used forSavings accounts

Money market accounts

Certificates of deposit

Checking accounts
Credit cards

Mortgages

Car loans

Personal loans

Purchase payment plans
Factors✔ Interest rate

X Fees

X Other loan costs

✔ Compounding interest
✔ Interest rate

✔ Fees

✔ Other loan costs

X Compounding interest
Will it fluctuate during the lifetime of the loan?Yes. Except for CDs, APY tends to change based on market conditions.Yes. Can be variable or fixed.
Why it’s importantHelps your money make money in the long termDetermines how much more money you’ll have to pay back on a loan than the principal

Simple vs. Compound Interest

Simple interest is the most basic form of interest, taking into account the principal (how much you borrow) and interest rate on the loan. The interest you pay (or earn) is a percentage of the principal.

For example:

InvestmentInterest rateTermInterest earnedBalance after three years
$10,0002.00%3 years$600$10,600

Compound interest, put simply, is interest earned on top of interest. When you add cash to a savings account or take out a loan, those funds accumulate interest, and at the next interval when interest is calculated (this could be done annually, quarterly, monthly, weekly, or even daily), you’ll see that amount increase based on the principal and the interest that’s already accrued.

For example:

InvestmentInterest rateTermInterest earnedBalance after three years
$10,0002.00%3 years (compounding annually)$612.08$10,612.08

In the example above, compound interest has earned you $12.08 more than simple interest over three years. In the long term, this can translate to hundreds or thousands of dollars more, if you save early and consistently in high-earning accounts.

Compound interest can be calculated online, using tools like this compound interest calculator from the U.S. Securities and Exchange Commission.

The Power of Compound Interest

Compound interest can be a powerful tool for your financial life — and the most important part is starting early. Deposits made in your early-to-mid 20s can “snowball” into a large sum of money (even millions of dollars) by the time you’re 60, all because of interest earned on top of itself.

In fact, saving diligently early on can mean more than the amount actually saved because of the additional time the money has had to accumulate value.

Keep in mind, though, that while compound interest can work for you when you’ve lent money (putting cash into a savings account counts as lending money to the bank), it can also work against you when you’ve borrowed money from a lender (i.e., car loans, mortgages).

How to Maximize Interest

Save Early and Often

When you start saving can be just as important — if not more — than how much you save. Given the magic of time, your funds can grow to a sizeable nest egg, even if you stop investing additional amounts of money.

Bank Online

In addition to perks like stock rewards and early payday, online banks offer some of the highest APYs in the industry. Take advantage of high-yield savings accounts, CDs, and money market accounts, which often have APYs that are 10-20 times higher than what you would find at a traditional brick-and-mortar bank, and other saving instruments.

What’s Next?

Check out our reviews of the best online banks, savings accounts, checking accounts, money market accounts, and certificates of deposit.

What’s the difference between a credit union and a bank? We found the answer.

If you’ve received a windfall of cash, you could pay off debt or put it in savings. Here’s how to decide what’s right for you.
Read on for our tips for building an emergency fund.

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