Whether you *think* you completely understand what interest rates are and how they work, or you know that you definitely don’t know everything about them, this will lay out all the essential details.

While “interest” can feel like a dirty word for anyone with debt, there’s a lot more going on with these rates than the way they puff up the balance on your credit card. Since interest rates will invariably appear in nearly every aspect of your financial life, it’s incredibly important to understand the different types of interest and their implications on your financial plans. An interest rate has bearing on the size of your credit card bill, how long it takes you to pay off your mortgage or student loans — and it’s also what fuels your savings..

You probably already know a few things about interest rates, like that the principal balance of a loan is the amount you borrowed, and the interest is the money you pay on top of that every month as a fee for borrowing said money. What’s harder to determine is where interest rates come from (no, they don’t just appear out of thin air), how they work, and how they impact your money. Let’s dig into everything you need to know to speak interest rates fluently.

The Different Types Of Interest Rates

An interest rate on a savings, checking, or high-yield account will usually either have the term APR or APY attached. APR (annual percentage rate) tells you how much interest is paid in a given year, while APY (annual percentage yield) takes into account the year’s compounding interest. What’s compounding interest, you ask? Essentially, you earn interest on your interest, unlike simple interest, which is only based on the principal balance of a loan or investment.

For example, if you put $100 into an account with 5% simple interest, you’ll have $105 in a year and $150.00 in 10 years. Meanwhile, $100 in an account with 5% interest compounded monthly will be $105.12 in a year and $164.70 in 10 years. It works the same way for loans. If you take out a $10,000 loan with 5% interest that compounds monthly, you’ll owe $16,470 in 10 years (If you don’t make any payments, that is). Most mortgage loans, credit cards, and high-yield savings accounts will have compound interest.

Why Compound Interest Matters

Albert Einstein reportedly called compound interest “the eighth wonder of the world,” adding: “He who understands it, earns it; he who doesn’t, pays it.”
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