Interest rates are a central part of our financial lives, but they can also be confusing. Understanding how interest works is important to your personal finances, because it dictates the true amount of a loan or credit card balance. Interest rates also impact how much you save and the investments you make. Learn more about the different types of interest rates and how they are calculated.
Interest is both a cost of debt and the rate of return on an investment. When you borrow money, the interest you pay is based on the amount of time you take to repay it. For example, if you take out a payday loan for $100 that has to be paid back in two weeks, the annual percentage rate (APR) is 400%. This is because the fee of $15 is multiplied by the number of weeks to get the final figure.
When saving, interest is calculated by multiplying the deposit amount by the number of days in a year to get an annual percentage yield (APY). This figure can then be divided by the daily deposit amount to find how many dollars you earn per day.
Lenders use a variety of criteria to decide what interest rate to charge borrowers. These may include your creditworthiness, the likelihood that you will repay the debt on time and other economic trends. They may also use market rates, such as the Wall Street Journal prime rate, to determine loan rates.