Interest is as old as borrowing and lending itself, tracing back to ancient civilizations. This charge compensates lenders for the time, risk, and opportunity cost of parting ways with their funds, and it’s still a central part of our modern financial system. 

Read on as we further unpack how interest impacts borrowers and lenders.

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What’s interest?

When repaying a loan, interest is an additional amount of money added to the amount you were loaned. You can think of it as a rental fee you pay for access to funds. In the same way, if you’re investing money, interest is the amount you collect from whoever is accessing your money — compensating you for making those funds available. 

Whenever interest is in the conversation, two abbreviations commonly pop up: 

• The annual percentage rate (APR) measures the yearly cost of borrowing money as a percentage. In most cases, the APR also includes borrowing fees, such as administrative or processing costs. 
• Annual percentage yield (APY) represents the effective annual rate of return of an investment or deposit, accounting for the effect of compounding interest over the course of a year. 

In other words, APR tells borrowers how much interest they’ll pay over a year, while APY lets investors know how much interest they’ll earn over a year.

Interest accrues based on the principal, the original sum of money that is borrowed or contributed. For instance, if you borrow $100 at 10% annual interest, the principal is $100. After one year, you would owe $110 in total — $100 principal + $10 interest.

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How does interest work?

Although most financiers set interest rates on an annual basis, they may also calculate them monthly or even daily. This is great for accounts you’re earning on but can lead to higher costs for borrowed funds. 

To illustrate, let’s take a look at three of the most common types of interest-bearing accounts.

How does interest work on a savings account?

Your bank likely offers a savings account where you can earn interest on your principal. While the average APY sits at just above 0.4%, some high-yield savings accounts offer upwards of 5%. 

Many banks also provide compounding interest, which means you can earn interest on your interest. Hypothetically, you deposit $100,000 in a savings account offering 2% interest that compounds annually. In the first year, you’d make $2,000. In the second year, you’d accrue 2% on your total account balance of $102,000, leading to $2,040 in gains.

How does interest on a credit card work?

Credit card interest is the fee you’re charged if you don’t pay your statement balance in full each month. 

If you carry a balance from one month to the next, the issuer applies interest to the amount you owe until it’s paid off. Most card issuers start by converting your APR to a daily rate. Then, they multiply that rate by your average daily balance and add the result to your total due. 

Hypothetically, if your APR is 18%, that’s a daily rate of approximately 0.05%. So, on a $1,000 balance, you’d owe approximately $15 in interest over a 30-day billing cycle.

How does interest work on a loan?

When you take out a loan, the lender considers several factors to determine your final interest rate. These factors may include current market conditions, your credit score, and the size of the loan. Not all rates are set in stone — some lenders offer variable options that change with market conditions. 

Beyond calculating what you pay in interest, lenders can also determine how you pay it. Most loans are amortized, meaning you put a set, scheduled sum toward both the principal and accrued interest. But some only require interest payments until the principal is due at the end of the term as a lump sum.

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What’s accrued interest?

Think of accrued interest as owed but unpaid interest. Hypothetically, say you own an asset that entitles you to interest payments twice a year — once at the start of the year and once in the middle of the year. If you sell that asset in March, the entity that issues or holds the asset still owes you interest for January, February, and the portion of March before the sale. That interest amount counts as accrued interest until paid by the entity.

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Simple vs. compound interest

The two most common types of interest are simple and compound interest. Simple interest only affects the original principal. If you contribute $100 in return for a 5% simple annual interest rate, you’ll receive a set amount of $5 per year. 

Compound interest is more powerful: It accumulates based on both the initial principal and any interest from previous periods. If you contribute the same $100 in return for 5% compound annual interest, your earnings will look like this:

• Year one: $100 + 5% = $105
• Year two: $105 + 5% = $110.25
• Year three: $110.25 + 5% = $115.76

As time goes on, compounding interest's effects only become more pronounced. Here are two scenarios to illustrate this:

• Example one (simple interest): Over his 30-year career, John Doe invested $3,000 per month into an account that offered a 7% simple interest rate. When it came time for retirement, John Doe had about $2,200,000. 
• Example two (compound interest): Over the same 30-year timeline, Jane Doe invested $3,000 per month into an account with a 7% compound interest rate. She entered retirement with about $3,660,000. 

These examples of interest accrual show how compounding accounts are central to a well-built retirement portfolio.

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Fixed vs. variable interest

Fixed interest rates remain the same throughout the loan or term. Borrowers like these rates because they’re predictable and steady, so loan payments will be a consistent expense. 

On the other hand, variable interest rates change over time. Market conditions, benchmarks like the federal funds rate, and changing economic factors can all impact variable accounts. 

Investors looking for steady growth tend to prefer fixed accounts, while those interested in higher earnings might opt for variable. For example, consider how interest affects annuities: 

• Fixed annuities: Offered by insurance companies at a guaranteed interest rate in return for principal. Because the rate doesn’t change, your money is protected from market downturns but you may miss out on potential earnings if the market performs well. 
• Variable annuities: Insurance companies invest your money in accounts like stocks, bonds, and money market funds. These accounts affect the variable annuity’s rate of return — if they perform well, so does the annuity.

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3 financial products that have interest

The majority of savings and investment vehicles involve interest. But they vary significantly in how financers calculate, accrue, and distribute that interest.

Let’s compare how this works across three popular interest-paying options.

1. Annuities

There are many types of annuities that cater to different stakeholder preferences. Some prefer conservative but stable fixed annuity rates. But others are more interested in the capital gains potential of variable and indexed annuities. 

As an annuity holder, you generally have several distribution options. Depending on your contract, you may choose to receive interest payouts monthly, quarterly, or annually. Alternatively, you can allow the interest to compound until your annuity enters the payout (or annuitization) phase.

At that stage, you can opt for a fixed income stream for life, payments over a specified period, or a lump-sum payout.

2. Bonds

Bonds are a type of debt security that governments and corporations use to raise money. When you invest in a bond, you lend money to the issuer. In return, the issuer promises to pay you periodic interest in addition to repayment of your principal. 

There are many types of bonds, including corporate, municipal, and treasury. The U.S. government issues treasury bonds, and they’re generally considered among the safest investments. They offer fixed interest rates, averaging 4.79% over the past three decades. 

But not all interest rates are set in stone — some adjust on specified dates, while others pay interest in the form of additional securities rather than cash. 

3. Mutual funds

Mutual funds pool money from multiple investors to buy a diversified portfolio of stocks, bonds, and other securities. 

Whether a mutual fund offers interest depends on the types of securities it holds. Funds that hold income-generating assets may pass interest earnings to investors in the form of dividends. Typically, these payouts are distributed quarterly, semi-annually, or even annually. 

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This communication is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice.