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Interest: Sometimes you earn it, sometimes you pay it, and many people often do both. Whatever your situation, it’s an important concept to grasp. Interest plays a role in your financial life via credit card rates, mortgages, auto loans, student loans, savings accounts and more. Here’s why interest is a big deal.
What is interest?
Interest is essentially the cost of borrowing money. The Federal Reserve (also referred to as the U.S. central bank or “the Fed”) is a government entity that oversees financial institutions and dictates interest rates. The federal funds rate is the rate at which banks can lend money to each other, and which the government raises and lowers to help regulate the economy. This figure—which impacts other short-term interest rates—is currently near historic lows, so while you might not be earning much interest on a savings account, you’re also likely able to lock in a 30-year mortgage or a car loan for a relatively low interest rate.
On the flip side, in 1987, when the federal rate was higher, you might have earned about 7% interest on a savings product such as a certificate of deposit (CD); but at the same time, your mortgage rate was likely more than 10%.
Interest you earn
Interest has the potential to work in your favor when you have savings or investment accounts. Consider the following hypothetical scenario:
Say you’ve been hard at work putting away savings for your financial confidence account (congrats!) and you currently have $5,000 saved in an account that earns 1 percent annual interest. While that’s still a bit higher than most rates you’ll see today, this means you’ll earn $50 of interest on your savings each year. It may not sound like much, but you’ve earned extra money through interest without having to do any additional work—score!
This is an example of simple interest. But fortunately for you, most accounts earn compound interest, which means the dollars collected as interest are essentially reinvested to earn interest themselves. Let’s consider the same example.
You’ve saved $5,000 in your financial confidence account, and after one year, you’ve earned $50 in interest. With compounding interest, the following year you would also earn 1 percent on the $50 of interest—so, an extra $2.50:
Understanding compounding interest is a key first step toward learning how your money can work for you.
Interest you pay
Consider the following scenario. You’re buying a new car and need a $15,000 loan. You are offered an interest rate of 4 percent, based on your credit score and current rates.
Challenge:Before you apply for a loan, be sure to know your credit score, as this will impact your interest rate.
Even just a small change to the interest rate can make a big difference in what you pay. Say you were offered a 5.5% interest rate on that same car loan. That doesn’t sound much different, right? But to repay the loan in full, you’d be paying $2,191 in interest, or $616 more—an extra $123 per year.
Whether you are borrowing money or investing it, you will be affected by interest. Understand how it works so you can make it work for you.
- You can earn interest or pay it. Many people will do both at the same time.
- Compound interest grows your money faster than simple interest.
- Even a small increase or decrease in interest rate can have an impact on how much you may be spending or saving.
Challenge yourselfFeeling confident in your savings strategy and ready to start investing? Keep reading to learn about how you can get started and stick to your values.
1 “Fed Funds Rate History: Highs, Lows and Chart With Major Events,” Aug. 2, 2017, The Balance
2 “30-year Fixed Mortgage Rates Since 1971,” Freddie Mac
3 “Historical CD Interest Rates – 1984-2016,” April 19, 2016, BankrateThis content is educational in nature and does not constitute legal, tax, accounting, financial or investment advice. You are encouraged to consult with competent legal, tax, accounting, financial or investment professionals based on your specific circumstances. We do not make any warranties as to accuracy or completeness of this information, do not endorse any third-party companies, products, or services described here, and take no liability for your use of this information.
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