Earners Want to Know: What Are Interest Rates?
Interest plays a role in almost all aspects of personal finance, including savings, investing, credit, and loans. Interest is money that's added to your starting balance. It’s typically expressed as a percentage. That percentage is known as your interest rate.
You can earn it or pay it. This article focuses on those looking to earn interest on their savings or investments. Part 2 will focus on the interest you pay on loans and credit cards.
What Are Interest Rates?
(When You're Earning Them)
You earn interest by keeping money in a bank or credit union account or making other investments.
It’s important to consider interest when choosing a financial product because the rate that you earn or pay can significantly impact your overall financial health.
For example, when you open a savings account, you will earn interest at a specific rate on a regular schedule. How much you earn depends on the interest rate the bank offers.
Earning 0.02% interest on $1,000 in a savings account will end up earning you approximately an extra $0.20 over the course of 1 year. (Unfortunately, most savings accounts don't pay high rates right now, due to several market factors we'll discuss below.)
If you were lucky enough to have an interest rate of 5% on a $1,000 deposit, that would be an extra $50 at the end of the year. Big difference, as you can see!
What should you be saving for? We covered this with Arizona's Treasurer Yee in a recent webinar. Check it out On Demand: How to Prioritize Your Savings Plan: Short-term vs. Retirement vs. Education 529 Savings Plan. You can grab a copy of our free savings quick reference guide while you're at it, too!
Interest Rate vs. APY
Although some people use these two terms interchangeably, there is a difference!
When banks and credit unions discuss interest rates for their savings accounts, they’ll tell you both the nominal rate (interest rate) and the annual percentage yield (APY). These apply mostly to savings accounts, but some free checking accounts also pay an interest rate!
The nominal, or named rate, is the rate they pay. The APY is what you earn in a year, expressed as a percentage. How are they different? Let's take a look at another example:
If you deposit $1,000 into a savings account with an annual interest rate of 5%, you’ll earn $50 that year for a total of $1,050.
But if the interest compounds monthly (more on compounding later), you’ll actually earn about $51.16 for a total of $1,051.16. The APY is slightly higher than the nominal rate, at 5.12%.
Simply put, the APY factors in compounding, whereas the nominal rate does not.
How Do Banks and Credit Unions Determine What Interest Rate They'll Pay?
When determining the nominal rate they’ll pay, financial institutions must consider:
1) How much they are earning on loans (this is where financial institutions get much of their income.)
2) How much it costs them to borrow money from other banks and credit unions.
Both of these factors are affected by the Federal Reserve Bank - often referred to as "The Fed" which governs monetary policy in the USA.
It's a complicated topic, but in a very general sense it could be said that when loan rates are lower, savings earning rates are also low. When loan rates go up due to a variety of factors, savings rates can go up too.
If you're wanting to start saving but just don't know where to begin, our 10-Day Challenge: A Budget Organizer to Easily Improve Your Financial Health might be a simple and fun place to start.
Am I Earning Simple Interest or Compound Interest?
What you actually earn depends on whether the account pays simple or compound interest. Simple interest is calculated annually – once per year – on the amount you deposit.
Once per year, your new total deposit is calculated. That new number is what you earn interest on for the following year.
With compound interest, interest is added to your original balance to form a new base on which you earn the next round of interest. Each bank or credit union account has guidelines which determine whether interest accrues daily, monthly, or quarterly. Compounding is like hitting the ‘total’ button on the calculator multiple times a year and then earning on the new total each time. Simple interest just ‘totals out’ once a year.
When interest compounds in a savings account, the base amount in your account always increases, though it will be slower with simple interest than it would be with compound interest. For example, if you deposit $1,000 into a savings account with a 5% interest rate, compounding annually/simple interest, you’ll earn $50 in interest the first year for a total of $1,050. The next year, you’ll earn 5% of $1,050, or $52.50, for a total of $1,102.50.
Where the Phrase “Time is Money” Comes From
Ok, we admit this phrase could mean a lot of different things, but compounding interest is why you hear the phrase “the sooner you start investing/saving the better.” That’s because the interest you earn on your investments are reinvested to form a new base on which future earnings can grow. As that base gets larger, the potential for growth increases. The more time you have to let it grow, the more you’ll have at the end. If you're looking for some simple savings options, check out our post on the 3 Best Savings Accounts Every Arizonan Should Have.
Most of us get tripped up because we can't find money left over to put into savings, so we end up putting it off and losing out on the beauty of compounding interest. If this sounds like you, you should check out our budget plan eBook that walks you through step-by-step how to determine your income and expenses, and help you get some green into that savings account sooner rather than later.