What exactly is interest?

As a consumer, interest rates are a foundational part of your personal finances. You’re either paying interest on a mortgage or car loan, or you’re collecting it through savings and checking accounts or other investments. 

Interest is a pretty simple concept, but it can take some time to wrap your head around how to use it to your advantage. And, equally important, how to assess if a credit product will cost you more than you’re willing to pay. 

Here’s how interest works: 

Let’s get started with a definition  

In everyday finance, interest is classified as either an annual percentage rate (APR), which is the interest a borrower pays a lender on a loan amount or annual percentage yield (APY), which is the interest earned on savings products and certain investments. 

In both examples, interest is expressed as a percentage of the sum of money and usually calculated on an annual basis. 

The interest formula for APR is - APR= (((Interest + Fees ÷ Loan amount) ÷ number of days in loan term) x 365) x 100 

The interest formula for APY is – APY = (1 + (interest rate ÷ compound frequency)]^{cf –} 1 

Compounding interest is when the interest you earn is added to your balance and generates additional interest. For example, if you deposit $100 and interest brings it up to $105, you earn future interest on $105. Every time you earn interest, the trend continues — you’re earning interest on your interest! Comparatively, non-compounding interest, known as simple interest, is when you deposit $100, it earns $5, but you only earn interest on the $100 — you’re only earning on what you directly put into the account. 

For clarity, compound interest is almost exclusively for savings products and investments. If you ever come across a loan that charges the borrower compound interest, run. 

How are interest rates set? 

Interest rate ranges stem from policy set by the Federal Reserve Bank. Its control of the nation’s money supply acts as a lever to raise or lower interest rates. How much financial institutions charge or pay in interest is influenced by the federal funds rate, which itself is influenced by Fed policy and other factors including competition in the marketplace and inflation. When the federal funds rate increases, financial institutions raise APRs to offset the increased costs. The reverse is also true. 

Principal: Principal is the amount originally borrowed and approved before any interest or fees are assessed. Principal and APR are adjacent concepts in that the higher the principal, the longer it may take to pay back and therefore the more time that APR can be charged. 

How are my personal annual percentage rates chosen? 

While interest ranges are set by the federal reserve, the exact rate you’re charged on a credit product varies based on: 

Credit score/history: The better one’s credit and the longer they’ve had good credit, the lower their APR will be.  

Loan type: The average home loan APR is between 4-6% and the average car loan is between 7-10% APR. Comparatively, the average credit card APR is between 18-23%. A home or car loan with a 23% APR would be practically criminal. Understanding what’s a big or small APR for a given loan product can help you decide if it’s worth it for you. 

Loan term: The longer the loan term (the time you have to repay the loan), the higher the interest rate might be.  

Watch out for subprime lenders 

Subprime lenders are lenders that lend to borrowers that other financial institutions won’t. Typically, the borrowers have poor credit history and limited income. Subprime lenders often charge far, far, far higher than average annual percentage rates. This can trap a borrower in a loop of constantly paying high interest charges and never having enough money at once to pay off the loan.  

Good habits pay off 

How much you pay in interest for loans can depend on your credit score. Lenders take risk into account when setting loan rates. Low-risk borrowers reap the benefits. 

Now that you’ve got the rundown on interest, it’s time to start using it in your favor. Check out how you can save more with OCCU interest-earning accounts or how you can pay less over the long term with our low rates on car loans and mortgages.