What is Interest? Everything You Need to Know

August 25, 2021
financial literacy

When you’re saving for a child’s future, it helps to find strategies for your money to grow more quickly. 

The more your money grows, the more you’ll have for a child’s future, whether it be their college education, a business they hope to start, or helping them to buy their first home.

But how do you actually grow your money? 

One of the simplest ways to see your money grow is by earning interest.

Interest is basically the rate someone pays for borrowed money. In some cases, interest can work against you. But when it comes to saving for the future, it can work in your favor.

In this article, you’ll learn what interest is, how it works, and how to use it to invest in a child’s future.

What is Interest?

In short, interest is the price you pay to borrow money. 

When someone borrows money, they agree to pay it back with an additional amount of money, known as interest. 

Interest has many applications. It’s used in consumer and business lending for credit cards, personal loans, auto loans, student loans, mortgages, and more. It’s also used in banking products to reward consumers for keeping their money in a certain type of account.

Interest provides an incentive for individuals and financial institutions to lend money. 

For banks to lend money to consumers, they have to be able to earn a profit. Similarly, for consumers to keep their money in a particular account for a long period, there has to be a reward.

What is an Interest Rate?

An interest rate is an amount you pay on the money you borrow, or the amount you earn on certain deposits. 

Interest is typically a percentage of the amount borrowed. For example, if someone borrows $100 at a rate of 5%, then the total interest they’ll pay is $5 (5% of $100).

The interest rate on a particular loan can make a considerable difference in the amount the borrower must repay. 

For example, a credit card can often have an interest rate of 20% per year or more. With a $10,000 balance at 20% interest, you could pay more than $5,000 in interest if you pay the card off over five years.

But other types of loans can have interest rates of just a few percent. If you borrowed a car with the same $10,000 principal amount and five-year repayment period, you could pay less than $1,000 in interest if you had an interest rate of 3%.

Interest rate vs. APR

If you’ve borrowed money or seen marketing for lending products, then you’ve probably heard the term APR before and may have wondered how it differs from an interest rate. Are interest rate and APR the same thing?

APR stands for annual percentage rate. It’s typically the rate you’re quoted for a loan, and it may be equal to the annual interest rate — but not always.

Sometimes the APR is made up of more than just the interest rate. The APR can consist of both the interest rate and any other fees the lender wrapped up into your loan, such as origination or management fees. 

For example, you might borrow a personal loan with an interest rate of 5%, but the APR on the loan is 5.5%, and that’s how much you’ll actually pay.

Types of Interest

When we talk about interest, it’s critical that we speak on the difference between the two different types of interest: simple interest and compound interest.

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Simple interest

Simple interest is the easiest to calculate, and it’s the type of interest most commonly used in consumer lending products like mortgages, auto loans, and student loans.

In the case of simple interest, you only pay (or earn) interest on the loan balance. For example, suppose you take out a personal loan of $5,000. The loan accrues interest each month, but you’ll only ever have to pay interest on the amount you initially borrowed.

Simple interest often accrues daily, weekly, or monthly. How often the interest accrues can ultimately impact the amount of interest you’ll pay.

Let’s go back to that personal loan example of $5,000. 

Suppose you had an annual interest rate of 6%, and interest on the loan accrues monthly. Rather than getting charged 6% of the loan amount once a year, you’d get charged 0.5% (1/12th of 6%) each month.

So, on a $5,000 loan, you’ll be expected to pay $25 each month in interest. 

Compound interest

The other type of interest is compound interest. Unlike simple interest, where only the principal balance accrues interest, compound interest occurs when accrued interest is added to the principal balance and also begins to accrue interest.

As you can imagine, compound interest results in far more interest accruing since you have more money accruing interest. 

The good news is that most situations where compound interest applies are those that favor consumers, like savings accounts and other deposit accounts. The exception is credit cards, which have compound interest that works against consumers.

Suppose you deposited $1,000 into a savings account with an annual interest rate of 1%. After the first year, your account has accrued $10 in interest.

But the following year, the 1% interest rate doesn’t just apply to the $1,000 you deposited. Instead, it applies to the entire $1,010 in the account. After the second year, you’ll have $1,020.10. Each year, your account will grow by slightly more than it did the previous year.

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Paying Interest vs. Earning Interest

Interest can either work against you and cost you money or work for you and earn you money.

Interest works against you when you borrow money. You’re likely to pay interest on any type of lending product, including credit cards, student loans, auto loans, mortgages, personal loans, etc.

You might find that the higher the interest rate, the more difficult time you’ll have paying off your debt. In the case of credit cards, for example, the interest rates can be so high that it can take years for an individual to pay off a relatively small amount of debt.

But interest can also work for you when you’re the one lending money. 

Consider a savings account, for example. When you put money into a savings account, your bank lends that money out to other customers. In exchange for using your money, the bank pays you interest.

How to Earn Interest

As we mentioned previously, interest can work in your favor when you put money in certain types of accounts. Here are a few different products that allow you to earn interest income:

Savings accounts

A savings account is a type of deposit account that you’d find at any type of bank or credit union.

Traditionally, savings accounts haven’t been the best place to earn interest. Sure, they served as a place to keep your money safe. But you might only earn a few cents of interest per month.

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In recent years, more financial institutions — specifically online banks — have begun offering high-yield savings accounts. While they still won’t make you rich, these accounts often pay many times what a traditional savings account might pay. 

Certificates of deposit

A certificate of deposit (CD) is a banking product that banks offer to customers who agree to keep the money deposited for a certain amount of time.

CDs often have higher interest rates than savings accounts. But in return, customers have to agree to keep their money in the account for a few months to several years. 

As a result, these accounts are best-suited for any money you don’t expect to need before the end of the CD term. If you withdraw your money early, you could pay an early withdrawal penalty and lose some or all of your accrued interest.

Money market accounts

A money market account is a type of deposit account you might find at your financial institution. These accounts are like a hybrid between savings accounts and checking accounts.

Money market accounts are like savings accounts in that they pay interest and you’re limited to the number of withdrawals you can make each month. But they’re also like checking accounts because they often come with debit cards and check-writing capabilities.

Historically, money market accounts had more generous interest rates than traditional savings accounts. But with the increase in the availability of high-yield savings accounts, you might find that the returns between the two are comparable.

Money market funds

Despite the similarity in the name, a money market fund isn’t the same as a money market account. A money market fund is a type of mutual fund that invests in debt instruments like bonds, commercial paper, Treasury bills, and more. 

Because a money market fund is an investment account rather than a deposit account, they have a bit more risk. However, because they invest primarily in low-risk securities, they’re generally considered low-risk as far as investments go.

Bonds 

A bond is a debt security issued by a government or corporation. When you invest in bonds, you’re essentially giving a loan to the issuing entity. In return, the bond’s issuer makes interest payments throughout the life of the loan. Then, when the bond reaches its maturity date, the issuer pays back the full amount they borrowed.

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Bonds are considered a low-risk alternative to stock investing. Because many bonds are issued by government entities, they’re often backed by the US government. And except in the case of certain junk bonds, the companies that issue corporate bonds often have good credit rates.

It's important to note that bonds do still have a small risk that the issuing entity could default and fail to repay its lenders.

What is a good interest rate?

You might be wondering what sort of interest would be considered a “good” rate on a banking product. The interest rate you expect to earn on any product depends on several factors:

  • The economy: Financial institutions base their interest rates on the current market rate. When interest rates in general rise, so do the rates on banking products and vice versa. 

Because of the pandemic, the Federal Reserve slashed interest rates, which caused the rates on many banking products to decrease, both to the benefit and detriment of consumers (depending on whether you’re borrowing or lending).

  • The risk level: In general, there’s a direct correlation between risk and reward — the higher the risk you take on, the greater the financial reward. 

Certain accounts, like savings accounts and certificates of deposit, are risk-free since the money is protected by Federal Deposit Insurance Corporation (FDIC) insurance. Because bonds and money market funds have a greater risk, they also often offer higher interest returns.

  • The term: Certain interest products require you to keep your money invested for a certain amount of time before you can earn your full return. And in general, the longer the term, the higher the interest rate. 

Examples of such products would be certificates of deposit and bonds, both of which have maturity dates. If you cash out a CD before the term ends, you could pay an early withdrawal fee. And in the case of bonds, selling before the maturity date could result in lost interest payments.

Alternatives to Earning Interest

Earning interest is one way that you can increase your money, especially when you’re saving for a large expense, like your child’s college education. But interest isn’t the only strategy, and you can use it alongside other types of investments to earn even more.

The other most common strategy you might use to grow your money is through stock investing. When you buy a share of stock, you’re essentially buying a small part of ownership in the company that issued it.

Stock investing can be profitable in two ways. 

First, investing in stocks is profitable when you’re able to sell an investment for more than you paid for it. This type of profit is known as a capital gain.

The other way you can earn money with stock investing is through dividends, which some companies pay their shareholders on a quarterly basis as a way of passing along some of the company’s profits.

Building your investment portfolio

Deciding what type of investment products to include in your portfolio can be overwhelming. When you open a custodial account with EarlyBird, we make it easy on you by offering you the option of five different ETF portfolios.

The five portfolios range from conservative to aggressive. 

The conservative portfolio is made up entirely of bonds, while the aggressive portfolio is made up entirely of stocks. The other three portfolios are made up of both stocks and bonds, meaning you can take advantage of interest earnings, as well as dividends and capital gains.

Conclusion

Interest is the rate you pay to borrow money. But it doesn’t necessarily have to work against you. When you put your money in certain types of accounts and investments, you can start to see interest work in your favor as you watch your money grow.

When you’re saving for a child’s future, interest is just one piece of the puzzle. When you diversify your investments, you can take advantage of the various ways to grow your money.

Download EarlyBird on the app store today to start investing in the kids you love.

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