What is an interest rate, and how does it work?

Interest rates are a fundamental concept in finance that play a crucial role in our everyday lives. Consumers making a big purchase factor interest rates into their decisions about loans. Market watchers follow them for what they say about business conditions and corporate prospects. The Federal Reserve (Fed), the US central bank, adjusts them to keep the economy running smoothly. What is an interest rate, how does it work, and why does it matter?

What is an interest rate?

An interest rate is the cost of borrowing money. If you’re the borrower, you pay interest. If you’re the lender, then you get paid interest. (When you put your money in a bank account, for example, you’re essentially lending the bank your money to fund other loans and investments.) The rate is usually expressed as a percentage of the principal (the amount of money borrowed or lent) per period of time, typically a year.

Many factors help determine interest rates across the economy, including the supply and demand for money, the inflation rate, and the monetary policy set by the Fed. High interest rates make borrowing more expensive, which can slow economic activity. Conversely, low interest rates make borrowing cheaper, potentially stimulating economic activity. For savers and investors, higher interest rates may mean higher returns on their money. Understanding how interest rates work can help you make informed financial decisions, whether you're taking out a loan, saving for the future, or investing in assets.

Simple interest vs. compound interest

Simple interest and compound interest are two ways interest can accumulate. Simple interest is calculated only on the initial amount, or principal, that you deposit or borrow. For example, if you put $1,000 in a bank account with an annual simple interest rate of 5%, you'll earn $50 in interest after one year. You'll continue to earn $50 each year you keep your money in the account.¹

Compound interest builds on the initial principal along with the accumulated interest of previous periods. Think of it as earning interest on interest. Using the same example, if you deposit $1,000 in a bank account with an annual compound interest rate of 5%, you'll earn $50 in interest after the first year, just like with simple interest. However, after the second year, you'll earn interest on $1,050 (your initial $1,000 plus the $50 in interest from the previous year), so $52.50 rather than just $50. After the third year, you’ll earn $55.13 on $1102.50. This compounding effect can lead to significantly higher returns over time.²

Nominal interest rate vs. real interest rate

Nominal interest rates and real interest rates are two ways of looking at how an interest rate affects the principal. The nominal interest rate — typically advertised for savings accounts or loans — ignores inflation and bank fees. The real interest rate accounts for inflation and fees to give a more accurate picture of the return or cost.

If, for example, the nominal rate is 5% at your bank and inflation is 3% in the economy, the real rate is only 2%. Your savings may be growing at 5%, but the purchasing power of that money is only growing at 2% thanks to rising costs. So, in real terms, your $1,000 would only have the buying power of $1,020 at the end of the year, not $1,050.

Fixed interest rate vs. variable interest rate

Fixed and variable interest rates apply to loans and credit products, and each comes with benefits and drawbacks. A fixed interest rate is set at the time of the loan and stays the same for the life of the loan. For instance, if you take out a car loan with a fixed interest rate of 6%, your monthly payments won’t change over the term of the loan. This predictability can make budgeting easier, as you know exactly what your payment will be each month.

Variable interest rates can fluctuate over time. These rates are typically tied to a benchmark interest rate, such as the prime rate. If the benchmark rises, so does your variable interest rate and your monthly payment. If the benchmark falls, your interest rate and monthly payment will too. Variable rates can potentially offer savings if interest rates decrease. But they also introduce a level of uncertainty, as your payments can increase if rates rise.

What is the federal funds rate?

When you read headlines about the Fed raising or lowering interest rates, this is the rate they’re talking about. Changes in the federal funds rate can affect the economy and your personal finances.

The federal funds rate is what banks and other financial institutions charge each other for very short-term loans, typically overnight. Banks take out these loans to meet their reserve requirements, which is the amount of money that regulators require them to have on hand each night. The Fed sets a target for the federal funds rate as part of its role in managing the country’s economy.

When the Fed lowers this rate, borrowing money becomes cheaper. This can lead to lower interest rates on mortgages and car loans and encourage people and businesses to borrow and spend more. All of this helps the economy grow. On the other hand, when the Fed raises the federal funds rate, borrowing money becomes more expensive, which can lead to higher interest rates on loans and credit cards. This can slow spending and help keep inflation in check.

What are common interest rates?

Consumers have access to many financial products that rely on interest rates including savings accounts, bonds, credit cards, mortgages, and student loans. These are influenced by the direction of the federal funds rate.

Savings account

This deposit account lets a consumer store money securely — usually at a bank — and earn interest. The balance grows over time through compounding. However, depending on the inflation rate, the spending power of that money may not grow.

Bond

This investment is a loan to a government or corporation that earns interest. The bond issuer makes periodic interest payments to the bond holder over a specified time period, after which the original loan amount is returned.

Credit card

A credit card lets a consumer borrow money to buy things. The credit card issuer charges interest — the annual percentage rate (APR) — on the money borrowed, unless the balance is paid in full each month.

Student loan

A student loan is a loan from the federal government or a private institution used to pay for an education. Like other types of loans, they rely on interest as a cost of borrowing money, charging a percentage of the principal.

Mortgage

A mortgage loan is provided by a bank or other financial institution to purchase a home. The homeowner repays the loan, with interest, over a set time period, typically 15 or 30 years. The interest is calculated as a percentage of the outstanding loan balance.