Interest rates determine how much you pay on loans or earn on savings.
Jump to insightMortgages may have fixed or variable rates. Interest can be either simple or compound.
Jump to insightHigher interest rates increase borrowing costs but boost returns on savings.
Jump to insightInflation, the economy and Federal Reserve policy all play a role in setting rates.
Jump to insightInterest rate changes can ripple through the economy, raising or lowering consumer spending.
Jump to insightWhat is an interest rate?
An interest rate is the percentage charged on a loan or earned on a savings account. In both cases, it’s typically expressed as an annual percentage. For example, if you borrow $1,000 for a year at 5%, you’ll owe $50 in interest. If you put $1,000 into a savings account with a 1.5% annual interest rate, you’d earn about $15 in interest over a year.
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.
On loans, you'll see interest expressed as APR, which stands for annual percentage rate. APR represents the total cost of borrowing money for one year. This number includes any fees that are applied to the account. For example, if you borrow $1,000 for one year with an interest rate of 5% and a $100 origination fee, your APR will be 15.5% for the first year because of the 10% fee.
On savings accounts, you’ll see interest expressed as APY, which stands for annual percentage yield. This number 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 affect how much you can earn on savings or save on loans. The type of rate, whether it’s simple or compound, fixed or variable, changes how interest is applied over time. Some rates stay the same, while others change with the market. Some build gradually, while others accelerate as balances grow. These differences can have a big impact on your total costs or returns.
Simple vs. compound interest rates
Simple interest is calculated only on the original balance of the account. Compound interest is when the accrued interest is applied to the account and then also begins to earn interest.
Example: simple vs. compound interest
Savings accounts typically earn compound interest, while most loans use simple interest. But 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 on a savings account is good for the account holder since the applied interest makes the balance larger, thereby earning more and more each month as time goes by.
For example, a savings balance of $10,000 at 5% 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 $10,468.00, earning $43.62.
For loans, interest 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.
If someone borrows $10,000 at 5% and doesn't make a payment for two years, each month the interest will be added to the account and accrue interest. After two years, the balance will be $11,236.00, 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.
Fixed vs. variable interest rates
Interest rates are either fixed or variable. Fixed interest rates are commonly used for installment loans, such as car loans, where you borrow a specific amount and repay it over a set period of time. In savings, fixed rates are often applied to time-bound accounts such as certificates of deposit (CDs), where the rate remains the same for the duration of the term.
Variable rates are typically used when the accounts don’t have set time frames, such as credit cards or savings accounts. For these accounts, the interest rates will rise and fall based on market conditions.
When fixed rates are better than variable 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. However, you may end up locked into a less-than-ideal interest rate if the market changes during the term of your loan or CD.
Variable rates are better when you are 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.
How interest rates affect loans and savings
Interest rates affect how much you can earn on savings or save on loans. Rates come in several forms, and the type you have affects how much you’ll pay or earn over time.
Some are applied only to the original balance, while others build as interest accrues. Rates can also stay the same or shift with the market. These differences are what cause some loans or savings accounts to grow (or cost) more than others.
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, compounded monthly.
| Interest rate | Growth on $10,000 after one year |
|---|---|
| 1% | $100.46 |
| 3% | $304.16 |
| 5% | $511.62 |
| 7% | $722.90 |
| 9% | $938.07 |
| 11% | $1,157.19 |
| 13% | $1,380.32 |
| 15% | $1,607.55 |
| 17% | $1,838.92 |
| 19% | $2,074.51 |
» EXPLORE: The benefits of high-yield savings accounts
Interest accrues the same way when borrowing money, but instead of passively accruing interest, payments are made, which reduce the balance and affect the amount of interest accrued.
How loan costs increase with interest over one year
Here are some examples of the amount of interest paid on a $10,000 loan for one year at various interest rates, along with the corresponding monthly payment:
| Interest rate | Total interest paid | Monthly payment |
|---|---|---|
| 1% | $54.25 | $837.85 |
| 3% | $163.24 | $846.94 |
| 5% | $272.90 | $856.07 |
| 7% | $383.21 | $865.27 |
| 9% | $494.18 | $874.51 |
| 11% | $605.80 | $883.82 |
| 13% | $718.07 | $893.17 |
| 15% | $831.00 | $902.58 |
| 17% | $944.57 | $912.05 |
| 19% | $1,058.79 | $921.57 |
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 strength of 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 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 leads to lower interest rates.
The rate of inflation
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 sets the federal funds rate. This is the interest rate that the Federal Reserve charges when it loans funds to banks. A bank will need to charge a borrower a higher interest rate than it’s paying.
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.
When asked about the Federal Reserve's impact on interest rates, Chris Motola, special projects editor and financial analyst at National Business Capital, said: “The Fed has a dual mandate. What this has traditionally meant is (that) 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 use your credit score, your debt-to-income ratio and other factors to determine the risk.
Riskier borrowers are usually charged higher interest rates as a way for lenders to offset potential losses.
Loan term length
The longer the loan term, the greater the risk. The future is unpredictable; the economy can shift, and circumstances can change for both the borrower and the lender. For example, a borrower who is stable today may face difficult financial times in the future.
To account for this added 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.
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.
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.
To slow inflation, the Federal Reserve can raise the federal funds rate, the rate banks pay to borrow from the Fed. When that happens, banks raise interest rates for businesses and consumers, making borrowing more expensive and slowing down spending.
Anthony Saccaro, president at Providence Financial & Insurance Services in Woodland Hills, California, said: “Interest rates play a big role in this dynamic. 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.
“When rates are high, borrowing becomes more expensive. 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,” Saccaro said.
We saw this after COVID-19. As restrictions lifted, demand surged and inflation rose. In response, the Federal Reserve raised the federal funds rate. Mortgage rates, for example, jumped from 2.65% in January 2021 to 5% by April 2022.
The Fed can also lower interest rates to boost spending during economic slowdowns. Cheaper borrowing encourages more consumer and business activity, which can help stimulate growth.
FAQ
How exactly do interest rates work?
Interest rates work by setting the cost of borrowing and the reward for saving. For example, a $5,000 deposit at a 5% annual rate compounded monthly would earn $255.81 in one year.
What does an interest rate of 7% mean?
An interest rate of 7% on a loan means that you'll pay an amount equal to 7% of the average balance over the course of the year. For example, if you borrow $1,000 at 7% for one year, you'll pay $38.32. It's not 7% of the full $1,000 because the balance of the loan decreases as you make payments.
On a savings account, an interest rate of 7% means that you'll earn an amount equal to 7% of the balance of your account per year. For example, if you save $1,000 at 7% for one year, you will earn about $70, depending on how the interest is compounded.
How much is 5% interest on $250,000?
If you borrow $250,000 at 5% on a 30-year mortgage, you'll pay $12,416.19 in interest for the first year or about $1,035 per month. However, if you save $250,000 at 5% for one year, you'll earn $12,790.47.
How do banks set interest rates on loans?
Banks use a variety of factors to determine interest rates on loans. Some are economic, such as the inflation rate and the overall demand for loans. Others are specific to the borrower, such as their credit score and debt-to-income ratio.
» LEARN: How does the Rule of 78 work?
Article sources
ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
- Wells Fargo, “Certificate of Deposits (CDs).” Accessed June 30, 2025.
- Citi, “What is a Fixed Interest Rate?” Accessed June 30, 2025.
- The Library of Economics and Liberty (Econlib), “Interest Rates.” Accessed June 30, 2025.
- California Credit Union, “What Are Interest Rates and How Do They Work?” Accessed June 30, 2025.
- Amres, “Understanding The Connection Between Loan Term and Interest Rate.” Accessed June 30, 2025.
- Vanguard, “How government bonds are taxed.” Accessed June 30, 2025.
- Harvard Business Review, “What Causes Inflation?” Accessed June 30, 2025.
- International Monetary Fund, “Inflation: Prices on the Rise.” Accessed June 30, 2025.
- Consumer Financial Protection Bureau, “Data Spotlight: The Impact of Changing Mortgage Interest Rates.” Accessed June 30, 2025.
