Interest rates play a critical role in your financial life, determining how much your debt costs and what you can earn on savings or investments. It’s important to understand how different types of interest rates work, especially because they can differ by loan type and even the individual financial institution you are dealing with.
There are two main types of interest: simple and compound. Simple interest is calculated on an initial principal amount and does not take into account any interests earned or paid in previous periods. It is typically used for short-term loans and investment products such as certificates of deposit (CDs) and money market accounts.
Compound interest is a mathematical formula that takes into account interest earned and paid in previous periods. This is how most credit cards, auto loans and mortgages are calculated. It is often quoted as an annual percentage rate, or APR, but can be calculated for any period of time. APR may also include additional fees such as late charges and other loan costs, so it’s a good idea to compare the various options available when shopping for loans and saving accounts.
There are many factors that influence how much you earn or pay in interest, including the economy, your bank policy, and the credit-worthiness of your lender. You can’t control some of these, but you can make certain decisions to help ensure that the interest rate you receive is as low as possible.