How Does Interest Work?

Interest is the cost of borrowing money or the reward for lending it. When you take out a loan, you pay interest to the lender in exchange for the risk they're taking on. When you deposit money into a savings account, the financial institution pays you interest in exchange for being able to use your money while it sits there. Interest rates, which are what determine how much interest you pay or earn, are set based on a mix of national economic factors and your own financial profile.

If you've ever opened up a savings account or taken out a loan, you've heard the term interest before. You also probably have a rough idea of what it means, if you have a loan, you have to pay more money back than what you borrowed, and if you have savings account, you get a bit of money back each month.

Interest Rates Explained

The concept of interest is actually pretty simple. It’s a fee that a borrower pays a lender as compensation for the risk of loaning their money out.

For example, let’s say you take out an auto loan to buy a car. After talking with a loan advisor at a financial institution, you get a loan of $6,000 at 5% interest, also known as the interest rate. What this means is that the financial institution is giving you $6,000 for the purposes of buying an automobile, and you in return are paying them five percent of that amount, or $300, in addition to repaying the $6,000.

The same principle works when you open a savings account, CD or IRA. When you put your money in any of these investment vehicles, you are basically setting it aside for the financial institution to use. In return, the financial institution pays you for the privilege of being able to use your money.

Interest Terminology: APR vs. APY

Once you understand the basic concept of interest, the next step is knowing the difference between the two terms you'll see attached to almost every rate: APR and APY.

APR stands for annual percentage rate. It's the simple annual rate of interest you'll pay or earn, without accounting for how often the interest is applied.

APY stands for annual percentage yield. It includes the same annual rate, but also factors in how frequently interest compounds, which means it's applied not just to your original balance but to the interest you've already earned.

Here's what that looks like with real numbers. Say you deposit $1,000 into a savings account with a 5% rate.

• At 5% APR (simple interest, no compounding), you'd earn $50 in interest after one year, for a total of $1,050.
• At 5% APY (interest compounded monthly), you'd earn about $51.16 after one year, because each month's interest gets added to the balance before the next month's interest is calculated, for a total of about $1,051.16.

The difference looks small over one year, but it grows the longer your money stays invested, which is why APY is the more accurate number to compare when you're shopping for savings accounts or CDs.

How Interest Rates Are Set

It’s one thing to know what interest is. It’s another thing entirely to know how financial institutions set interest rates. The short answer is that a lot of factors intertwine to determine how interest rates are set. Among these factors are:

• The Federal Reserve’s federal fund interest rate. This is the rate that financial institutions use to lend to one another and trade with the Federal Reserve itself.
• The prime rate. This is the interest rate financial institutions give to their ideal customers, usually corporate accounts. This interest rate is generally set three percent higher than the federal fund interest rate.
• Market information. Once financial institutions know the federal fund interest rate and have established their prime rate, their analysts will start examining outside information to determine the interest rates for different loans. Among the information an analyst might consider is inflation, the level and growth of the Gross Domestic Product and the ups and downs in market rates, known as interest rate volatility.
• Personal information. When you try to get a loan from a financial institution, that institution will first look at how much you want to borrow and the period of time in which you plan to pay the loan back. They’ll also check your credit score and evaluate what other accounts you’ve held with the institution and for how long. In the case of some loans, such as a mortgage, they’ll take into account what kind of down payment you’re making, as well. All of this information will be used to assess what kind of risk you pose to the financial institution and assign an interest rate to you that will sufficiently cover the financial institution’s risk in lending you the money.

Take Advantage of First Alliance Credit Union's Interest Rates

If you want to know more about the interest rates for savings accounts or loans, contact our team of experts at First Alliance Credit Union. Our advisors will ask you questions about your financial goals and then work with you to get the best possible interest rate.

Still have questions about how interest rates work? Ask us!