Interest rates have been a topic of high
interest this year, no pun intended 😄. Prompted by rising inflation, the Federal Reserve, which is the Central Bank of the United States, has been steadily raising
interest rates in 2022. This is great for savers but not so great for borrowers. This can be a lot to take in 🤯, especially on the heels of a global pandemic. I’m going to take a moment to break down what
interest is and how it can impact you both positively and negatively.
First off, what is it?
Interest is additional money that someone receives when they save money. On the flip side, it is also additional money that someone pays when they borrow money.
Say you go to the bank and
open a new savings account. You deposit $100 and the
interest rate or Annual Percentage Yield (APY) is 2%. That means that for every $100 you deposit and leave in your account, the bank will pay you $2 by the end of the year. While some banks may pay once a year, generally they pay
interest monthly or quarterly, so you will get a fraction of the $2 each time they deposit
interest into your account. However, if you don’t deposit any more money, by the end of the year your savings account balance of $100 will now be $102.
That’s not a bad deal. All you had to do was put $100 in an account and forget about it and you got $2 for free 💰. If you had put $500 in they would have given you $10. Someone who keeps $5,000 in an emergency fund could get $100 a year! You can think of
interest as a free prize 🏆 you get for saving money. At the time of writing, there are many accounts out there that are actually paying 2%
interest or more right now in high-yield savings accounts (HYSAs!) Find out what the rate is for your current savings account to see if it’s
time to shop for a new one.
While the
interest in your savings account is a prize, it’s not quite the same when you borrow money in the form of a loan. Say you take out a loan for $1,000 to get a root canal. The
interest rate is quoted as an Annual Percentage Rate (APR) of 10%. That means that if you took out the loan and didn’t make a single payment for one year, you would owe $100 in
interest in addition to the $1,000 you borrowed 😮. If you didn’t think $100 was a lot in the last example, I’m sure you’ve changed your mind now.
Some good news about this, if you actually took out $1,000 as a personal loan from your bank, your loan would probably not sit there untouched to accrue $100 in
interest over the year. That is just an example to simplify the idea. What would actually happen is slightly more complicated but in your favor. Your bank will probably ask you to make payments on your loan each month. This type of plan reduces the amount of
interest you will have to pay back. If you took out the loan in January and paid all of it back by December, you would pay $54 in
interest instead of $100 😅. That’s because the bank is recalculating your
interest each month based on how much money is left on the loan, not how much you took out to start with. So each month when they recalculate, your loan balance is going to be smaller and smaller. This means that with each payment the $100 you could have theoretically owed in
interest is shrinking smaller and smaller.
One last thing before we wrap up - what is the difference between APY and APR? They are basically the same, it just depends on whether you are paying interest or receiving it.
Annual Percentage Yield (APY) signals that you will be receiving interest such as in a bank account and Annual Percentage Rate (APR) signals that you will be paying interest such as on a loan. Don’t get too hung up on this because even then the terms are sometimes used interchangeably. The takeaway is that APYs and APRs are standardized so that
if you compare interest rates from different banks, you know that you are comparing apples 🍎 and apples 🍏 instead of apples 🍎 and oranges 🍊. Otherwise, one bank might quote a monthly
interest rate while another one quotes an annual rate which would be not only confusing but misleading.
If the concept of
interest was an onion 🧅 (last food pun, I promise,) then we just peeled off the top two layers. There is much more to know about it in terms of loans and investments, but you now have the knowledge to
shop and compare rates at different banks which is a great starting point for your financial journey. If you’re in the market for
a new savings account, you can now look at APYs to see who is offering the highest rate and feel confident that you are making the right decision for your money 💸.
*To keep things simple, some of the examples use simple interest calculations. Different loans and bank accounts may have different types of interest.
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What is a High-Yield Savings Account?How to Choose a Bank AccountWhat is an Emergency Fund?How to Choose a Bank or Credit Union