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Interest shows up just about everywhere in your financial life, whether it’s the extra amount you pay back on a loan or the bump in your savings account balance each month. But how does interest work?
This article breaks down how interest is calculated, why rates vary, and how it can support your retirement plan.
What is interest and how does it work?
Interest is the fee you pay for using someone else’s money o the payment you receive for letting someone use your money. It’s calculated as a percentage of the total amount you borrowed or saved, which is called the principal.
What does interest rate mean in practice? Simply, it’s the percentage that determines how much extra money you’ll pay or earn over a given period. When that percentage corresponds to an entire calendar year, it’s called an annual rate. A higher interest rate means you owe more when you borrow money. But high interest also means you earn more on savings and investments. For example, if you deposit $100 into a high-yield savings account with an interest rate of 3%, you’ll earn $3.
How interest works when you borrow money
When you take out a loan or mortgage or use a credit card, you typically owe your lender more than what you borrowed. Banks and other lenders charge interest on a loan based on risk levels. A lender needs to protect itself in case you default or fail to pay back what you borrowed. A borrower with a strong FICOⓇ credit score usually qualifies for a lower interest rate because the lender thinks you’re more likely to pay what you owe.
How does interest work on a personal or auto loan?
A lump sum of money that you borrow and pay back over a set period of time is called an installment loan, a category that includes personal, auto, and student loans. The number of months you have to repay the loan, called the term, helps determine your monthly payment.
Say you get an auto loan for $40,000 with an annual rate of 10%, and you agree to pay back that loan in five years, or 60 months. Your lender will use a set formula to calculate your monthly payment, which in this example equals $849.88 a month.
Paying $849.88 a month for 60 months equals $50,992.80 total, or $10,992.80 more than the $40,000 you originally received. That extra amount reflects the interest that you paid. Each monthly payment you make is split; part of it covers the principal of the loan, and the rest goes toward the interest, which is calculated as a percentage of your outstanding loan balance. Because your balance is highest in the early months of the loan, those first payments mostly go toward the interest and not the principal. This is part of how interest works on a loan: If you want to pay less overall, you can pay back the loan faster with extra payments each month. Some lenders charge a fee for paying off a loan early, so it’s always a good idea to read the fine print of your contract before making a decision.
How does interest on a credit card work?
Interest for credit card debt is generally calculated differently than it is for installment loans. If you pay off your credit card each month, you typically aren’t subject to interest. But if you only make the minimum payment (which is typically only a small percentage of your total balance), you’ll be charged interest in the amount that carries over into the next month. Card issuers charge interest on that balance, which typically accrues and compounds daily. That means the interest you owe gets added to your balance, and the next day’s interest is calculated on that new, larger amount. In general, the longer you carry a balance, the more it costs you.
Fixed vs. variable interest rates on loans
Interest rates for loans are usually fixed or variable. A fixed rate stays the same for the entire term of the loan, so your payments are predictable from start to finish. A variable rate can move up or down over time. It’s usually tied to the market, which responds to the federal funds rate set by the Federal Reserve. When the Federal Reserve cuts rates, borrowers with a variable rate often see a lower interest rate on their next statement; when it raises rates, payments can climb. Borrowers who want stability often prefer fixed rates, while those willing to accept some uncertainty for a potentially lower starting rate might choose a variable rate.
How interest works when you save or invest
Interest rates work in your favor when you save or invest money through a savings account, stocks, bonds, or annuities. In each case, you let a financial institution use your money for a set period, and they pay you interest in return. This turns your savings into an income-generating asset. Annuities are insurance contracts issued by an insurance company; they are not bank deposits, savings accounts, or investments, and are not FDIC insured.
Knowing how lower and rising interest rates affect each type of asset can help you find the right product for your retirement needs.
How does interest work on a savings account?
Banks pay you interest on the money in your savings account because they use your deposits to fund loans for other customers. You should know how your bank calculates interest for different savings accounts, which can include a money market account or CD. CDs generally use fixed rates while money market accounts use variable rates, but that’s not always the case.
How Gainbridge products use interest for guaranteed growth
Gainbridge Save℠, a fixed annuity contract offers fixed-rates that give you a predictable rate of interest. This is different from variable annuities, where your growth is tied to how underlying investments perform. Your interest payments work quietly in the background, compounding over time so your balance grows steadily and predictably, and you’re protected even if the market goes down. Guarantees are subject to the terms and conditions of the contract and the claims-paying ability of the issuing insurance company. Early withdrawals may be subject to surrender charges, a market value adjustment, and tax penalties.
Simple vs. compound interest
Not all interest works the same way, and the type of interest you’re dealing with can have a big impact on how much you pay on debt or earn on savings.
Simple interest calculation and examples
Simple interest shows up in certain short-term loans and some fixed-term financial products where the terms are set in advance. It is calculated with the following formula:
A=P×1+rt
- A: the total amount after t years, including interest
- P: principal (initial amount you borrow or deposit)
- r: annual interest rate (as a decimal)
- t: total number of years
Let’s say you deposit $1,000 into an account with a simple annual interest of 5% for three years:
$1,150=$1,000×1+.05×3
So after three years, you would earn $150 and have a total balance of $1,150
Compound interest calculation and long term impact
Compound interest is calculated on the principal plus any interest that’s already been added, so your money grows faster over time.
The formula for compound interest is:
A = P1 + rnnt
- A: the total amount after t years, including interest
- P: principal (initial amount you borrow or deposit)
- r: annual interest rate (as a decimal)
- n: the number of times the interest compounds each year
- t: total number of years
The longer your money compounds, the more it grows. Say you deposit $10,000 at a 5% rate for 10 years.
With simple interest:
$15,000=$10,000×1+.05×10
If your interest compounds annually:
$16,288.95 = $10,0001 + .0511×10
You would earn an extra $1,288.95 with compound interest as opposed to an investment with simple interest. That difference matters when you factor in inflation, which erodes your money’s purchasing power for goods and services over time. If your deposit compounds at a rate higher than inflation, your money can retain its real value.
Put interest and Gainbridge Save℠ to work for you
Understanding how interest works can help you make better financial choices. If you want to owe less when you borrow money, you might prioritize paying off balances with a high interest rate. And when you invest, you can look for opportunities to let compound interest make your money work for you.
If you’re ready to get guaranteed, predictable growth for your money with no hidden fees or commissions (surrender charges may apply to withdrawals during the guarantee period), explore Save to see current rates and terms.
This article is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. The Gainbridge Save℠ digital platform provides informational and educational resources intended only for self-directed purposes.
FAQs
How often is interest compounded on savings accounts?
It depends on the account, but many savings accounts calculate interest daily and compound it into your monthly balance. The more frequently interest compounds, the faster your balance grows.
What is APR and how is it different from interest rate?
An annual percentage rate (APR) represents the total amount your loan or debt costs you each year. It includes your annual interest rate plus any additional fees from the lender.
Can interest rates change after I take out a loan?
If you have a fixed-rate loan, your interest rate stays the same for the life of the loan. If you have a variable-rate loan, your rate can change over time based on market conditions.
How can I reduce the amount of interest I pay on debt?
Paying more than the minimum payment, paying off high-interest debt first, and improving your credit score over time can all help you qualify for a lower interest rate and reduce how much interest you pay.
What factors determine the interest rate I receive on savings?
Your interest rate on savings is typically influenced by the account type, term length, and broader market conditions. A fixed annuity contract, like certain types of annuities, can protect you from rate drops down the road.
