What is interest?

Interest is one of the most consequential influences on our financial system, and arguably within the entire economy. It affects the cost of pretty much everything we buy, especially big purchases like cars and homes. Understanding interest is likewise an important lesson in everyone’s financial education.

The Federal Reserve’s decision to either hike or slash interest rates is always a topic of discussion and receives considerable media coverage. You might have read that in June 2022, the Fed hiked its benchmark interest rate by 0.75 percentage points, which has been the largest increase since 1994. But what even is interest? How does it impact you and why does it exist?

Think of interest as the cost of borrowing and the reward for lending money. It is typically calculated as a percentage of the principal amount, which is the total amount that is borrowed or lent. This percentage is known as the interest rate. Interest payments are made periodically – daily, monthly, annually, semi-annually – or depending on the agreement. Some financial instruments that offer interest to investors include savings accounts, cash deposits (CDs), commercial deposits, bonds, and more.

Apart from banks, you can also consider joining credit unions, which also offer similar products. The difference is that, unlike banks, credit unions are cooperative, nonprofit, member-owned financial institutions. As their customer, you’ll also be a member and owner. Thus, you’ll be receiving dividends instead of interest. Because credit unions are nonprofit, they return extra funds to members as dividends.

You might have heard of the time value of money – a dollar today is always worth more than a dollar tomorrow. This is because of inflation. As prices increase, the purchasing power of the same amount of money decreases. So when a lender decides to lend someone their money, they’re essentially foregoing their ability to spend the money today. This is the opportunity cost the lender incurs – or other alternatives on which the lender could have spent the money. To incentivize the lender to lend money, additional interest must be paid on the principal amount that is lent.

Now that you understand the motivation behind interest, let’s discuss how interest works. Lending and borrowing are different sides of the same coin.

Using the same logic, you’re giving up on your ability to spend the money today when you deposit or save money in your bank account. This allows banks to lend your money to other borrowers, who pay back the amount to the bank with interest. Subsequently, the interest you earn on your deposits is a fraction of the interest the bank receives through its lending activities. Banks typically charge a higher interest to their borrowers than they give to their depositors. This net difference is how banks earn profits.

The interest you receive is directly proportional to the amount of your deposit and the time period you keep it for. A higher amount, kept for a longer period, leads to a higher interest.

Conversely, when you borrow money, you have to repay the lender the principal amount as well as the interest. Typically for loans, the periodic payments you make contribute towards repaying the principal as well as the accrued interest. You should carefully verify the interest you’ll be paying over the lifetime of the loan before borrowing.

On the other hand, for revolving loans, such as credit card debt, you can continue to borrow for as long as you need, provided you don’t overshoot your credit limit and make the minimum monthly payments.

Before you borrow or lend money, it is critical to understand the different ways that interest can be calculated. Depending on which one is applied, your interest amounts and repayment structure can vary substantially.

In the case of simple interest, you earn periodic interest payments, depending on the rate, on your principal amount. Even as your principal begins to grow, you only receive interest on the original principal amount. On the flipside, with compound interest, you earn interest on the principal as well as the accrued interest from the previous time periods. This implies that your money is “compounded,” and as the timeframe gets longer, the gap between simple and compound interest broadens.

For example, consider this scenario: you invest $100 at 5% yearly interest rate. In the simple interest scenario, you would get a $5 interest payment (5% of 100 is 5) every year on the original $100, that is, your deposit will grow by increments of $5 every year. So, in year one your total investment would increase to $105, then $110 in the second year, $115 in the third, and so on.

In the compound interest case, you would also receive an interest payment of $5 in your first year. However, the difference begins in the second year and onwards – every subsequent interest payment will be based on the total amount, instead of the original deposit. So, in year 2, you’ll receive a 5% interest on $105, which is $5.25, making your total deposit $110.25. In the next year, your interest will be 5% of $110.25, which is $5.51, and so on. You can see as the timeframe grows, compound interest increasingly offers higher interest payments than simple interest.

The power of compounding is even more impactful when interest is compounded more frequently. Raisin, for instance, compounds interest on a daily basis. Find out more about how interest works on a savings account by clicking here.

As the name suggests, fixed vs variable rates determine whether the interest rate changes over the duration of the loan. While fixed rates remain constant throughout the life of the loan, variable rates change with the prime rate. This introduces some amount of uncertainty in the process. For example, if the rates rise in the future, the borrower will have to repay a higher amount in interest. Conversely, if the rates fall, the borrower will have to pay a lower interest amount to the lender.

It is crucial you choose the right interest type. As a borrower, if you expect the interest rates to fall in the future, you should consider the variable rate model, whereas if you predict the rates to rise, a fixed interest structure is more wise.

The annual percentage yield, or (APY), is often conflated with interest rate, but they’re different concepts. In simple words, APY tells you the annual earnings on your principal investment, while the interest rate is just part of the formula. The interest rate does not consider compounding by itself, which the APY does.

Further, it also considers how often interest is compounded. Not all interest rates are annual, some are monthly, quarterly, and semi-annual. The more frequently interest is accrued or compounded on your deposit, the bigger your principal will be at the end of the year. For example, a 5% interest rate will give a higher return when it is compounded quarterly (as you receive interest thrice in a year) as opposed to being compounded annually. This is why you should focus on APY when deciding the best savings instrument.

With the vast variety of products available in the market, it is difficult to select the right one for you. Raisin is your one-stop solution for all your savings related concerns. We offer deposit products, including savings accounts, money market accounts, CDs, and no-penalty CDs, with some of the best interest rates in the nation. Moreover, all savings products available through Raisin offer daily compound interest. And with just one account, you have the option to invest in a vast array of deposit products, offered by banks and credit unions, in a smart, safe, and simple manner.

The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.