What Is Interest?

Theresa Stevens is a personal finance writer based in Boston, MA. As a former financial advisor, she has first-hand experience helping people solve their money challenges. When she's not writing, you'll find her trying out a new karaoke spot or planning her next trip abroad.

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Elizabeth AldrichDeputy Editor, Banking

With eight years of experience as a financial journalist and editor and a degree in economics, Elizabeth Aldrich has worked on thousands of articles within the realm of banking, economics, credit cards, investing, loans, personal finance and travel. Her work has been featured in Business Insider, The Motley Fool, Bankrate, Investopedia, LendingTree, Student Loan Hero, ValuePenguin, USA Today, Credit Karma, NASDAQ, Yahoo! Finance and more.

Fact Checked

Elizabeth Aldrich

Elizabeth AldrichDeputy Editor, Banking

Deputy Editor, Banking

Fact Checked

Published: Oct 10, 2023, 9:29am

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When it comes to interest, you’re either paying it or earning it. Borrowers pay interest when they take out a loan or charge money to a credit card, while savers earn interest when they deposit money into savings accounts, CDs and money market accounts. But there’s more than meets the eye when it comes to understanding what interest is and how it impacts your finances.

What Is Interest?

Interest is a charge incurred for borrowing money. As a consumer, you can pay or earn interest depending on whether you’re borrowing or depositing money.

When you borrow money with a loan or credit card, you typically must repay the original amount, or principal, plus interest. When you deposit money into an interest-bearing account, such as a savings account, money market account or certificate of deposit (CD), you earn interest. This is because you’re essentially lending money to the bank. Banks use deposits in various ways, including providing loans to individuals and businesses and making investments.

Interest Rate vs. APY vs. APR

Understanding the differences between APR, APY and interest rates can help you make informed financial decisions.

An interest rate is the percentage of interest you earn or pay as applied to your principal balance. While the term interest rate is often used interchangeably with APY (in the case of savings) and APR (in the case of borrowing), they aren’t the same.

The annual percentage rate, or APR, describes the annual cost of borrowing money and reflects interest charges as well as fees and other loan charges. For this reason, APR is often considered a more accurate measure of total borrowing costs.

APY, or annual percentage yield, describes the amount of interest you’ll earn on your savings over the course of one year. APY accounts for the effects of compound interest, while an interest rate does not. An interest rate only calculates simple interest or earnings on the principal alone. You’ll notice that when a savings account lists both an interest rate and an APY, the APY is usually higher.

How Does Interest Work?

Interest can accrue (be calculated and added to) a balance daily, monthly, quarterly or annually. If you’re paying interest, you’ll typically be charged for it monthly, and you’ll see that charge added to your balance owed. If you’re earning interest, it will likely be credited to your account (added to your balance) daily or monthly. Interest may also be calculated and credited at different frequencies.

Let’s say you take out a car loan to help you pay for a new vehicle. You’ll have to repay the original amount you borrowed plus interest charges. A $25,000 car loan with a 5% APR and a five-year repayment period would cost $3,306.85 in interest, meaning you’d pay back a total of $28,306.85.

If you’re saving money, a savings calculator can help you estimate your interest earnings. If you were to deposit $5,000 into a savings account with a 4.00% APY and continue to contribute $100 monthly for five years, your final account balance would be $12,734.88. This figure includes the $5,000 initial deposit, $6,000 in contributions and interest earnings of $1,734.88.

Compound vs. Simple Interest

Compound interest allows you to earn interest on interest. If your interest compounds, that means interest earnings are calculated on your principal balance and any previous earnings that remain in your account. Simple interest is calculated solely on the principal.

If you deposit $10,000 into a savings account with simple interest and a 4.00% interest rate, your balance would be $14,000 after 10 years. If the same account offered compound interest with daily compounding, you’d have $14,917.92 after 10 years.

Note that credit unions usually refer to both simple and compound interest as dividends.

How Much Interest Will I Pay?

The amount of interest you’ll pay depends on various factors, including:

The amount you owe. The interest rate you pay is typically charged as a percentage of your total balance.
Type of product. Interest rates vary across lending products. For example, car loans generally have lower interest rates than credit cards.
Credit score. Someone with a lower credit score is perceived as a riskier borrower, which may lead lenders to charge higher interest rates. Borrowers with good credit may receive lower rates as lenders see them as reliable borrowers.

Calculators can help you estimate the amount of credit card interest you’ll pay in a month. Using a credit card interest calculator, enter your card balance, APR and billing period. If you’re paying back a loan, you can use our loan calculator to figure out how much you’ll pay in interest.

How Much Interest Will I Earn?

The amount of interest you’ll earn varies by bank, account type and the amount you deposit. CDs, money market accounts and savings accounts are three common interest-earning products.

According to FDIC data, CDs tend to earn higher interest rates, followed by money market accounts and then savings accounts. High-yield savings accounts are savings accounts that earn particularly high rates. Checking accounts can also earn interest, but they generally earn far less than other deposit accounts.

If you know your APY and how much you plan to deposit, an easy way to estimate your earnings is by using a savings interest calculator.