Understanding Interest Rates For Banking

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Understanding Interest Rates for Banking

Wall Street and financial districts around the globe are certainly worlds of their own. Banking for the common adult not involved in the dreamy cloud of daily financial work seems a little more scary:  interest rates, simple interest, compound interest, annual percentage rates, paying or receiving interest, CDs, money market and savings accounts, and the like. What’s it all mean?

Knowledge about money and how to save it to maximize personal returns can be nearly a walk in the park when you understand interest rates for banking. Maybe you don’t know too much about it, and that’s probably why you’re here. Good news: adulting starts now!

What’s Interest?

In the banking world, interest is ultimately a fee that can be paid or received; a payment to account for the use of borrowed assets. When a borrower or financial institution borrows an initial sum of money from a lender, they pay interest on the initial amount borrowed, also known as the principal sum. Adding interest causes the repayment amount to be higher than the principal sum.

Interest, in layman’s terms: you borrow a tool from your neighbor to fix your car. Once you’re done with it, you return the tool, say thank you, and give your neighbor freshly cooked pasta or invite them over for dinner that week.

Paying Interest

If money is borrowed from a lender or financial institution, you’ll owe interest on the principal sum. High interest rates cause the borrower to pay or receive more money, while low interest rates cause the borrower to receive or pay less money.

Receiving Interest

If you lend a borrower money, they will have to pay you interest. People with interest bearing checking accounts such as money market or savings accounts, also make interest on their money left in the bank. Wondering why?

Essentially, when account holders place money in their savings or money market, they are allowing their bank to use it. If someone has a money market account, they are paid interest on their money based on current interest rates in the money market, which acts as a financial investment instrument with high liquidity, making trading and investing very safe. Savers make interest on their money because money in the future is less valuable than money placed in the bank today, and interest on savings acts as a reassurance and repayment for any opportunity cost taken, such as not being able to buy something now because you have your money in your savings.

Another notable mention includes Certificates of Deposit, or CDs. This is a savings certificate with a fixed interest rate, and money cannot be withdrawn until the loan reaches its maturity date. A maturity date is the termination or due date in which money can be retrieved or must be paid in full.

What about an Interest Rate?

An interest rate is a percentage representing the actual amount charged on the principal sum, to be paid by the borrower for using the lender’s assets. Interest rates are commonly expressed as an annual percentage rate (APR).

Interest can be charged on various borrowed assets, including: cash, larger assets like buildings or vehicles, and consumer goods. Things like school, mortgage, or car loans are common borrowed assets that are charged interest.

Simple Interest

The simple interest formula is a quick way to calculate the interest charge on a loan. Simple interest is commonly used for vehicle loans, and occasionally for mortgages. You can figure out how much you’d pay or receive in interest:

Simple Interest = P (principal sum) x I (annual interest rate) x N (years)

For example: Borrowing $2,000 at a 7% annual interest rate for 7 months means that you would owe $81.67 in interest (2000 x 7% x 7/12).

If you’re wondering about that last number in the equation, 7/12 - it’s extremely important! Since the example asked for 7 months interest rate, you have to divide by 12 (number of months in a year) to find out the correct rate. To make sure you don’t run into any unpleasant surprises when calculating interest, always make sure to read the fine print. If the interest rate is stated monthly instead of annually, it will make your next credit card purchase much more expensive. So always check the period of time the interest rate is referring to!

Compound Interest

Compounding interest is a little different than simple interest. It can be thought of as “interest on interest,” and most banks and credit cards use this to pay interest on savings and money market accounts. It is the interest on the original amount of money, plus additional interest on all previously accumulated periods.

So, once you’ve initially gained interest in your savings account, you receive additional interest on that amount, and so on. It’s a great thing for all of us adulting out there. If you’re paying compound interest though, you’re likely paying more in interest fees. The formula to figure out compound interest is as follows:

Compound Interest: (A) = P x (1+ r/n)NT

Where A = final amount, P = principal sum, r = interest rate, n = number of times per year the interest is compounded, t = time in years

That formula might look a bit scary - don’t worry! Compound interest is understood in plain English as: the final amount in the savings account after (t) years, compounded (n) times, at an interest rate of (r), with an initial deposit of (p).

For example: You have a principal in your bank account of $2,000. Your bank compounds the interest 3 times a year at a 4% rate. How much is in your account at the end of the year?

CI = 2000(1 + .04/3)3 x 1

CI = 2000(1 + .0133)3

CI = 2000(1.0405)

$2,081.07 is in the account at the end of the year and you started with $2,000, meaning you made $81.07 in compound interest.

So, adults - we hope you’re interested in banking more than before. The next step is figuring out the amount of interest you pay and receive and adulting it from there, making any adjustments necessary to make your financial future as bright as possible!

mysimpleshow joins The Adulting School to help you understand interest rates for banking.


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Editorial Contact: Emily Cleary, emily.cleary@simpleshow.com

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Emily Cleary is a writer and content marketer with a background in higher education teaching, writing tutoring, and marketing. She holds a Master of Arts degree in Sociology and studied business in college. Emily writes various types of content online about software and technology,  education and learning, and business. You can contact her via LinkedIn.