Interest Rates and How They Work

How interest rates work

An interest rate is the percentage charged for borrowing money or the percentage earned on a savings or investment account. In both cases, it’s typically expressed as an annual percentage. Typically, interest accrues on a daily basis and is applied to the account monthly. The higher the interest rate, the more interest will accrue on the balance.

Interest rates for loans

On loans, you'll see interest expressed as both an interest rate and as an annual percentage rate (APR). APR represents the total cost of borrowing money for one year, including any fees.

For example, if you borrow $1,000 for one year with an interest rate of 5% and a 10% origination fee, your APR will be 15.5% for the first year because of the 10% fee.

Interest rates for savings accounts

On savings accounts, you’ll see interest expressed as an interest rate and as an annual percentage yield (APY). The APY includes any compound interest that accrues over the course of the year. As your account earns interest, that amount is applied to your balance, which then starts earning interest as well. These extra funds increase the actual rate you’re earning on your money.

For example, if you save $1,000 for one year with an interest rate of 5%, your APY is actually 5.116%. The extra 0.116% comes from the interest earned on the interest applied to the account.

Types of interest rates

Interest rates can be simple or compound and fixed or variable. These differences can have a big impact on your total costs or returns.

Simple vs. compound interest

Interest is calculated in two main ways:

Simple interest

Simple interest is calculated as a percentage of the original (or principal) balance of the account. Simple interest is typically used with auto loans, short-term loans, personal loans, student loans and some investment products.

Simple vs. compound interest

While most loans use simple interest, there are exceptions. Credit cards and some student loans can build compound interest if payments are deferred or balances carry over, making them more expensive over time.

Compound interest

Compound interest is calculated as a percentage of the principal plus accrued interest. The accrued interest will be applied to the account and also earn interest. Interest can be compounded daily, weekly, monthly, quarterly or annually, though daily compounding tends to be the most common.

Compound interest is typically used with savings accounts, investment accounts, credit cards and mortgage loans. Compound interest on a savings account is good for the account holder since the applied interest makes the balance larger, thereby earning more over time.

For loans, interest generally won’t compound unless your monthly payments are smaller than the amount of interest being earned. This can occur with loans that have deferred payments or those with payments based on income.

Fixed vs. variable interest rates

Interest rates are either fixed or variable.

Fixed interest rates

Fixed interest rates have the same rate over time. They’re used for installment loans, such auto loans, personal loans and mortgages. Some time-bound saving or investment accounts, such as CDs, also have fixed rates.

Fixed rates are better when you need stability. A fixed-rate loan has a predictable payment each month, and with a fixed-rate CD, you know exactly what the balance will be at the end of the term.

Variable interest rates

Variable interest rates change over time. They’re typically used with accounts that don’t have set time frames, such as credit cards or savings accounts, though they’re also commonly found with adjustable-rate mortgages (ARMs). For these accounts, the interest rates will rise and fall based on market conditions.

Variable rates are better when you’re expecting rate changes soon. If you take a variable-rate loan and rates fall, your interest rate will drop too, decreasing the cost of the loan. The drawback is that rates may not fall, and changing interest rates will change your minimum payment, making it hard to predict your expenses.

» RELATED: How to calculate loan interest

Example: How interest rates affect savings and loans

Interest rates affect how much you can earn on savings accounts or how much a loan will cost you.

For example, a savings balance of $10,000 at 5% interest would earn $41.67 in the first month. For month two, the new balance is $10,041.67. This balance would earn $41.84, bringing the total balance up to $10,083.51, which would continue to earn interest. This would continue month after month, and one year after the initial deposit, the balance would be $10,468, and it would earn $43.62.

In comparison, if someone were to borrow $10,000 with a 5% interest rate and not make a payment for two years, each month the interest would be added to the account and accrue interest. After two years, the balance would be $11,236, accruing $54.43 per month. If payments aren’t enough to cover the interest accruing when they begin, the loan balance will continue to rise.

How savings grow with interest over one year

Below are some examples of $10,000 invested or saved at various interest rates for one year with monthly compounding.

How loan costs increase with interest over one year

The table below shows the amount of interest paid on a $10,000 loan for one year at various interest rates, along with the corresponding monthly payment.

Factors influencing interest rates

Several factors determine the market interest rates. Some factors are based on the overall economy, while others are specific to the borrower.

The economy

When the economy is doing well, businesses are growing, and people are employed. This can lead to a higher demand for loans since people or businesses may feel comfortable increasing their expenses. The additional demand can lead to higher interest rates. As people spend more money, inflation may also increase.

The opposite is also true: When the economy is weak, businesses aren’t as interested in expanding, and individuals are more cautious with their finances. This decrease in demand generally leads to lower interest rates.

The inflation rate

When inflation is high and prices are rising quickly, lenders require higher interest rates to maintain their purchasing power. The nominal interest rate must account for both the real rate of return and the expected rate of inflation. For example, if inflation is at 4% per year, a saver will need an interest rate above 4% to preserve the purchasing power of their funds.

Again, the opposite is also true. When prices are stable, lenders and savers are both willing to accept a lower interest rate since the loss of value over time is less significant.

Federal Reserve policies

The Federal Reserve (the Fed) sets the federal funds rate, which is the interest rate that banks charge to borrow from each other overnight. The Federal Reserve will often increase interest rates when inflation is high to make borrowing less attractive, therefore slowing down spending in the overall economy. This can lower the rate of inflation.

“The Fed has a dual mandate,” said Chris Motola, a special projects consultant for National Business Capital. “What this has traditionally meant is it tries to set an interest rate that balances unemployment and inflation concerns. If unemployment is rising, the expectation is that the Fed will lower interest rates. If inflation is rising more than expected, the expectation is that the Fed will raise interest rates.”

Borrower risk level

When lending money, a lender must assess the likelihood of a specific borrower defaulting on the loan and failing to repay the amount owed. Lenders determine your interest rate based on factors like your credit score, debt-to-income (DTI) ratio and income. Riskier borrowers are usually charged higher interest rates as a way for lenders to offset potential losses.

Loan term length

The longer a loan term, the greater the risk. To account for this risk, lenders typically charge higher interest rates on longer-term loans. The same principle applies to savings: Banks often offer higher interest rates on long-term CDs because your money is locked up for a longer period of time.

Tax treatment of interest

Some interest is tax exempt, depending on the investment. For example, the interest earned from bonds issued by state governments is exempt from federal income taxes and sometimes state income taxes as well. Since investors don’t have to pay taxes on that income, they’re generally willing to accept a lower interest rate in exchange.

» LEARN: How the Federal Reserve affects mortgage rates

The economic impact of interest rates

Interest rates affect the economy, and the economy, in turn, affects interest rates. When the economy is strong, people are employed, businesses are profitable and spending increases. That added demand can push prices up, contributing to inflation.

The Federal Reserve can lower interest rates to boost spending during economic slowdowns.

“Interest rates play a big role in this dynamic,” said Anthony Saccaro, president of Providence Financial & Insurance Services. “When rates are low, it’s cheaper for consumers to borrow money to make large purchases, which often leads to more spending. As demand for goods and services increases, prices are pushed higher, which can drive inflation up.”

To slow inflation, the Fed can also raise the federal funds rate. When that happens, banks raise interest rates for businesses and consumers.

“When rates are high, borrowing becomes more expensive,” Saccaro said. “Consumers are less likely to take on new debt to buy homes, cars, or other big-ticket items. As spending slows down, demand for goods and services drops, which helps put downward pressure on prices.”

For example, we saw this during the COVID-19 pandemic. As restrictions were lifted, demand surged and inflation rose. In response, the Federal Reserve increased the federal funds rate 11 times throughout 2022 and 2023. And mortgage rates, for example, jumped from 2.65% in January 2021 to 7.76% by November 2023.

FAQ