Detailed Explanation
Interest is the price of using money. When you borrow, you pay interest to the lender. When you save or invest, you earn interest as compensation for lending your money.
Types of Interest
Simple Interest: Calculated only on the original principal. Formula: Principal × Rate × Time. Used for some loans and short-term calculations.
Compound Interest: Calculated on principal plus accumulated interest, leading to exponential growth. This is how most savings accounts and investments work-and how credit card debt grows.
Interest Rate Types
Fixed Rate: Stays the same throughout the term. Predictable payments, but may miss out if rates drop.
Variable Rate: Fluctuates based on market conditions. Payments can change, but may benefit when rates fall.
APR vs. APY
APR (Annual Percentage Rate): The simple annual rate, used for loans. A 12% APR means 1% per month.
APY (Annual Percentage Yield): Includes compounding effects, used for savings. A 5% APY actually returns more than 5% per year when compounded.
Examples
Interest You Pay (Debt)
| Debt Type | Typical APR |
|---|---|
| Credit card | 18-28% |
| Personal loan | 8-15% |
| Auto loan | 5-10% |
| Mortgage | 6-8% |
| Student loan | 5-8% |
Interest You Earn (Savings)
| Account Type | Typical APY |
|---|---|
| High-yield savings | 4-5% |
| CDs | 4-5.5% |
| Money market | 4-5% |
| I-Bonds | Inflation rate |
The Impact of Rate Differences
$10,000 credit card debt at different rates:
- 18% APR: $1,800/year in interest
- 25% APR: $2,500/year in interest
- Difference: $700/year
Why It Matters
Interest plays a significant role in personal finance:
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Debt Cost: High interest rates dramatically increase what you actually pay for purchases. A $30,000 car at 8% over 5 years costs $34,000+.
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Wealth Building: Earning interest (and investing for returns) is how money grows without additional work.
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Rate Shopping: Even 1% difference on a mortgage can mean $30,000+ over the loan term.
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Prioritization: Some people compare their debt interest rates to potential investment returns when deciding where to allocate funds.
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Time Value of Money: Interest is why $1,000 today is worth more than $1,000 in 10 years.
Understanding interest rates on debts and savings accounts can provide useful context for financial decisions.