Interest is the cost of borrowing money, or the reward for lending it

When you borrow money from a bank—through a loan, credit card, or mortgage—you pay interest. When you deposit money in a savings account or certificate of deposit, the bank pays you interest. Interest is expressed as a percentage of the amount borrowed or deposited, calculated over a specific time period, usually one year. The percentage is called the interest rate.

The bank uses your deposits to lend to other customers. The difference between what they pay you and what they charge borrowers is how banks make money. Understanding how interest accrues and compounds helps you see why the same $10,000 grows differently in different accounts, and why carrying a credit card balance costs more than you might expect.

Key Takeaways

  • Interest is a percentage of the principal amount, charged when you borrow or paid when you save, and calculated over a set time period.
  • straightforward interest is calculated only on the original amount; compound interest is calculated on the principal plus previously earned interest, making it grow faster.
  • The annual percentage rate (APR) tells you the true yearly cost of borrowing because it includes fees and how often interest compounds.
  • Banks set interest rates based on the federal funds rate, inflation, and how risky they consider the loan, which is why credit cards charge more than mortgages.

How straightforward interest and compound interest differ

straightforward interest is calculated only on the original amount you borrowed or deposited. If you borrow $1,000 at 5 percent straightforward interest per year, you owe $50 in interest after one year. After two years, you owe $100 total. The interest does not grow on itself.

Compound interest is calculated on the principal plus any interest already earned. Using the same $1,000 at 5 percent, after one year you have $1,050. In year two, the bank calculates 5 percent on $1,050, not the original $1,000, giving you $52.50 in new interest. After two years, you have $1,102.50. The difference grows larger over time because you earn interest on your interest. This is why compound interest is sometimes called "interest on interest."

Most savings accounts, certificates of deposit, and loans use compound interest. The frequency of compounding matters: interest compounded daily grows faster than interest compounded monthly, which grows faster than interest compounded annually. A savings account that compounds daily will earn slightly more than one compounding monthly at the same stated rate.

What the annual percentage rate (APR) actually tells you

The annual percentage rate (APR) is the interest rate expressed as a yearly figure, and it includes fees charged by the lender. For a credit card, the APR includes the interest rate but not transaction fees or late fees—only the cost of borrowing itself. For a mortgage or auto loan, the APR includes the interest rate plus origination fees, closing costs, or other charges the lender rolls into the loan.

The APR is more useful than the interest rate alone because it shows you the true yearly cost. A credit card advertising 0 percent APR for 12 months means you pay no interest during that period, but once the promotional period ends, the regular APR kicks in. A mortgage with a 3 percent interest rate might have a 3.2 percent APR if the lender charges $2,000 in fees and rolls them into the loan amount.

When comparing loans or savings accounts, the APR is the number to compare across different lenders, because it accounts for how they structure their charges differently.

Why interest rates vary between different types of accounts and loans

Banks do not charge the same interest rate to everyone. The rate you receive depends on the type of product, how risky the bank considers the loan, and the current economic environment.

A mortgage typically has a lower interest rate than a car loan, which has a lower rate than a credit card, because a mortgage is secured by the house itself—if you stop paying, the bank takes the house. A car loan is secured by the car. A credit card is unsecured, meaning the bank has no collateral if you default, so they charge more to cover that risk. A savings account earns less interest than a loan charges because the bank is paying you to use your money, not borrowing from you.

Your personal credit score also affects the rate you receive. Someone with a 750 credit score will receive a lower mortgage rate than someone with a 650 score, because the higher score signals lower risk of default. Banks also adjust rates based on the federal funds rate—the rate the Federal Reserve sets for banks to lend to each other overnight. When the Fed raises rates, banks raise the rates they charge borrowers and lower the rates they pay savers. When the Fed lowers rates, the opposite happens.

How interest accrues on loans you owe

When you borrow money, interest starts accruing when ready. On a credit card, interest accrues daily on your balance. If you carry a $5,000 balance at 18 percent APR, the daily interest rate is approximately 0.049 percent. Each day, the bank adds that amount to what you owe. If you pay the full balance before the due date, you owe no interest. If you pay only the minimum, interest compounds on the unpaid portion.

On a mortgage or auto loan, you make fixed monthly payments. Part of each payment covers interest; the rest reduces the principal. Early in the loan, most of your payment goes to interest. As you pay down the principal, more of each payment goes toward principal and less toward interest. A 30-year mortgage at 6 percent means your first payment is mostly interest; your last payment is mostly principal.

Student loans work differently depending on the type. Federal subsidized loans do not accrue interest while you are in school. Unsubsidized loans accrue interest from the moment they are disbursed, and that interest is added to the principal when repayment begins, meaning you pay interest on interest.

How interest accrues on savings accounts and deposits

Banks pay you interest on money you deposit in savings accounts, money market accounts, and certificates of deposit. The interest rate is typically much lower than what you would pay on a loan—currently ranging from near zero to around 5 percent depending on the account type and the bank, though these rates change frequently.

Interest on savings accounts is usually compounded daily and credited monthly. This means the bank calculates interest every day based on your balance that day, but you see the total added to your account once a month. If you deposit $10,000 in a savings account earning 4 percent APY (annual percentage yield, which accounts for compounding), you earn approximately $400 in the first year, but that $400 is added gradually throughout the year, not all at once.

Certificates of deposit (CDs) lock your money away for a set period—three months, one year, five years—in exchange for a higher interest rate. If you withdraw the money early, you pay a penalty. The longer the term, the higher the rate, because the bank knows it can use your money for longer without you touching it.

The relationship between inflation and interest rates

Interest rates and inflation are connected. If inflation is 3 percent per year and your savings account earns 2 percent, your money is actually losing purchasing power—you can buy less with it next year than you can today. Banks raise interest rates when inflation is high to encourage people to save rather than spend. They lower rates when inflation is low and they want people to borrow and spend instead.

The Federal Reserve watches inflation closely and adjusts the federal funds rate to try to keep inflation stable. When inflation rises, the Fed raises rates, which causes banks to raise the rates they charge borrowers and the rates they pay savers. When inflation falls, the Fed lowers rates, and banks follow.

Frequently Asked Questions

How is interest calculated on a credit card?

Credit card interest is calculated daily on your outstanding balance using the daily periodic rate, which is the APR divided by 365. If your APR is 18 percent, the daily rate is about 0.049 percent. Each day, the bank multiplies your balance by this rate and adds it to what you owe. If you pay your full balance by the due date, you owe no interest.

Why does my savings account earn so little interest?

Banks pay lower interest on savings because they are paying you to use your money, not borrowing from you. The rate also depends on the federal funds rate—when the Fed lowers rates, banks lower what they pay savers. High-yield savings accounts at online banks typically pay more than traditional banks because they have lower overhead costs.

What is the difference between APR and APY?

APR is the annual percentage rate without accounting for compounding. APY is the annual percentage yield, which includes the effect of compounding. APY is always equal to or higher than APR on the same product. Banks must disclose both so you can compare accurately.

Can interest rates change on my loan after I sign?

It depends on the loan type. Fixed-rate mortgages and auto loans lock in the same rate for the entire loan term. Adjustable-rate mortgages (ARMs) have a fixed rate for a set period, then adjust periodically based on market conditions. Credit cards can raise your APR if you miss a payment or if the bank decides to change rates, though they must give you notice.

Does paying off a loan early save me interest?

Yes. If you pay off a loan early, you stop accruing interest on the remaining balance. On a 30-year mortgage, paying an extra $100 per month toward principal can cut years off the loan and save tens of thousands in interest. Some loans charge prepayment penalties, so check your loan documents before paying extra.