How Interest Works

How Interest Works

Interest can be a powerful tool in your financial success. Here, you can learn more about interest, including what it is and how rates are determined.

What is interest?

Interest is the “magic” that helps your savings earn more money for you.

In basic terms, interest is the cost of borrowing money. If you borrow money, you will pay interest to the lender. If you save money (in an interest-bearing account) the bank will pay you interest.

You’ll see interest expressed as Annual Percentage Rate (APR) or Annual Percentage Yield (APY). What’s the difference?

  • The APR is the annual rate of interest your money will earn, without taking into account any compounding of interest within that year.
  • The APY is the annual rate of interest your money will earn in one year, and does take into account compounding interest.

Better than magic – compound interest

  • Simple Interest is interest paid on principal—the original sum of money invested—only.
  • Compound Interest is better for saving, because it allows you to earn interest not only on your initial deposit, but also on the interest that accumulates. Compound interest is added to the principal automatically when it is paid, and interest payments after that are figured on the whole sum: principal plus interest.

How Are Interest Rates Determined?

The U.S. Federal Reserve influences the interest rates you earn or pay through their monetary policy. They adjust their key interest rate to maintain the stability of the U.S. economy and financial system. The Federal Reserve regularly takes action on interest rates in response to economic ups and downs.

When interest rates are high, you earn more interest on your deposits, but you also pay higher interest rates on any money you borrow. When interest rates fall, you earn less interest on your savings, but it costs less to borrow money.

Some banks pay more interest on higher balances to reward account holders who have higher savings amounts.

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