Understanding how interest rates work may reveal opportunities to reduce the cost of debt or increase earnings on deposits.

  • Interest rates change the total cost of debt and the growth potential of deposits. It affects loans, credit cards, and deposit accounts in different ways.
  • There are multiple types of interest — simple, compound, and accrued — and each may influence how much you earn or owe over time.
  • Compounding frequency, loan terms, and whether a rate is fixed or variable all shape the total cost or return of a financial product.
  • Comparing rates, reading the fine print, and understanding how interest is calculated may help you save money on loans and maximize returns on savings.

If you have a savings account, certificate of deposit (CD), credit card, or auto loan, interest likely affects your day-to-day finances. In simple terms, interest is the cost of borrowing money and the reward for saving it. Many people know this basic concept, but some may not understand how interest rates are determined, why compound interest may either build wealth or create debt spirals, and how economic conditions affect the rates they pay and earn.

Knowing how interest works may help put you in control of both sides of the equation. Whether you’re comparing mortgage rates, choosing a savings strategy, or deciding whether to pay off debt early, interest plays an important role. These fundamentals will help you make more informed financial decisions.

What Is Interest and Why Does It Exist?

For borrowers, interest is the price of accessing money you don’t currently have. For savers and lenders, it provides a return on the money they’re willing to let others use. This creates a balance that keeps money flowing through the economy.

Banks and other financial institutions collect deposits from savers and pay them interest on the funds. They then lend that money to borrowers at higher interest rates. The difference between what they pay savers and what they charge borrowers is known as the net interest margin. This is one way financial institutions generate a profit, which covers their operating costs and allows them to remain a viable business.

Interest also reflects risk and the value of time. Due to inflation and opportunity costs (i.e., potential earnings lost by not investing the funds elsewhere), money available today is typically worth more than the same amount in the future.[1]  Lenders charge interest to account for this lost value and the risk that borrowers may not fully repay the loan.

How Interest Works in Banking

When you take out an installment loan, such as a mortgage, auto loan, or personal loan, a portion of each monthly payment covers interest charges, while the remainder pays down the principal (the amount you borrowed). Early in the loan term, a larger portion of your payment goes toward interest. As you pay down the balance, more of each payment applies to the principal.[2]

Many credit cards work differently. They typically have a grace period, which is the time between the end of the billing cycle and your payment due date. Paying the full balance before the end of the grace period typically allows you to avoid interest charges for that month.[3]  However, if you only make partial payments, interest accrues on the remaining balance at your card's annual percentage rate (APR).

When you deposit money into an interest-bearing account, such as a savings account, money market account, or CD, you become the lender. Financial institutions pay you interest and use your deposits to make loans to other customers, essentially sharing part of their profit with you.

Different Types of Interest

There are three primary types of interest, and each functions differently. When evaluating financial products, it’s important to understand how each one works and how it may influence the total amount you pay or earn over time.

Simple Interest

Simple interest is calculated only on the original amount of money borrowed or invested, also called the principal.[4] The formula is simple:

Principal x Interest Rate x Time Period

For example, when investing $1,000 at 5% simple interest for three years, you earn $150 in interest ($1,000 × 0.05 × 3). The total after three years is $1,150.

Simple interest is often used for short-term loans and some government bonds. However, it’s less commonly found in consumer banking products.

Compound Interest

Compound interest is calculated on both the principal and any previously earned interest. This allows money to accumulate faster because you earn interest on your interest.
Consider the same example of investing $1,000 at 5% interest, but assume it is compounded annually for three years.

  • Year one earns $50, bringing the balance to $1,050.
  • Year two earns 5% on $1,050 ($52.50), bringing the balance to $1,102.50.
  • Year three earns 5% on $1,102.50 ($55.13), for a final balance of $1,157.63.

In this example, a saver earns (or a borrower pays) $7.63 more on the same $1,000, due to the power of compounding.[5]

Most savings accounts, investment accounts, and credit cards use compound interest. For savers, this works in your favor. For borrowers carrying balances, it may work against you as each interest charge generates more interest charges.

Accrued Interest

Accrued interest is interest that has been earned but not yet paid or received. For example, many savings accounts calculate interest daily but pay the amount into the account once a month. The interest accumulating each day is accrued interest until it’s added to your account at the month’s end.

For bonds, accrued interest represents the interest earned between payment dates. If you buy or sell a bond between interest payment dates, the transaction includes accrued interest calculations to ensure you’re compensated fairly.

The Importance of Compounding Frequency

Compounding frequency refers to how often interest is calculated and added to your balance. This may affect your returns or cost over time.[6] Financial institutions typically use one of the following compounding frequencies:

  • Daily: Interest calculated and added every day (365 times per year).
  • Monthly: Interest calculated and added once per month (12 times per year).
  • Quarterly: Interest calculated and added every three months (4 times per year).
  • Annual: Interest calculated and added once per year.

Consider a $10,000 investment at 5% annual interest rate over one year, compounding at different frequencies:

  • Daily: $10,512.67
  • Monthly: $10,511.62
  • Quarterly: $10,509.49
  • Annual: $10,500.00

The differences appear small initially, but they grow substantially over longer periods. After 20 years with the same $10,000 investment:

  • Compounded daily: $27,182.82
  • Compounded annually: $26,532.98
  • Difference: $649.84 more with daily compounding.

When comparing financial products, consider compounding frequency in addition to the interest rate. A slightly lower rate with daily compounding may outperform a higher rate with annual compounding.

Understanding Interest Rates

Financial experts define interest rates as the percentage of a loan amount or account balance that is charged or earned over a specific period, typically expressed as an annual percentage. While this may sound simple, there are several variations of interest rates, and the differences may significantly impact your financial decisions.

Interest Rate vs. APR  vs. APY

On a loan, the interest rate is the percentage you’ll pay on the principal balance, while the annual percentage rate includes the interest rate plus additional fees and costs associated with the loan. For example, a mortgage APR may include origination fees, discount points, and other closing costs. 

Annual Percentage Yield (APY) accounts for the frequency of compounding, which gives savers a more accurate picture of their return on investment. 

Fixed vs. Variable Interest Rates

Fixed interest rates remain constant throughout the life of a loan or deposit account. With fixed rates, borrowers or savers know exactly how much they’ll pay or earn each month. This may make budgeting more predictable and protect borrowers from rising interest rates. However, borrowers won't benefit if market rates fall after locking in their rate, and savers won't earn more if rates rise during their deposit term.

Variable rates change based on market conditions and benchmark rates such as the federal funds rate. Borrowers may enjoy lower rates when rates fall, but pay more when rates rise. For savers, variable rates may offer the opportunity to earn more when market rates increase but provide less income when rates decline.[7]

Real vs. Nominal Rates

The nominal interest rate is the actual percentage you pay or earn. The real interest rate accounts for the impact of inflation on our purchasing power. For example, if you earn 3% on a savings account but inflation over that time period is 2%, the real return is only 1%.

This distinction becomes more important when making longer-term financial decisions. During periods of high inflation, positive nominal returns could result in negative real returns, resulting in a loss of purchasing power over time. When evaluating investments or long-term savings, considering both the nominal rate and current inflation trends may help you understand what you're actually gaining or losing.

Factors That Affect Your Interest Rate

Whether you're borrowing or saving money, several key factors may affect the interest rate you receive. For borrowers, lenders typically use the following criteria to assess risk and set pricing:[8]

  • Credit score: One of the primary indicators of lending risk. Borrowers with higher credit scores typically enjoy lower interest rates.
  • Loan type and collateral: Secured loans backed by assets like homes or cars may offer lower rates than unsecured loans, such as credit cards, since lenders face a greater risk if you default.
  • Loan repayment term: Shorter loan terms may have lower interest rates, but higher monthly payments. Conversely, longer loan terms may have higher interest rates with lower monthly payments.
  • Down payment: Larger down payments reduce the lender’s risk, which may result in lower interest rates.
  • Market conditions: Economic factors such as Federal Reserve policy, inflation, and overall demand for credit may influence interest rates across the financial system.
  • Financial institutions: Banks, credit unions, and online lenders may offer varying rates based on factors such as their business models, overhead costs, and competitive positioning.

For savers, interest rates are generally determined by the account type, minimum required account balance, and the bank’s need for deposits. High-yield savings accounts and CDs typically offer better rates than traditional savings accounts, while larger balances may qualify for premium rates at some institutions.

The Bigger Picture: Interest and the Economy

The Federal Reserve sets the federal funds rate, which is the rate banks charge each other for overnight loans. This influences virtually all other interest rates. When the Fed raises rates to combat inflation, mortgage, credit card, and loan rates typically rise as well. Conversely, when the Fed cuts rates to stimulate economic growth, borrowing becomes less expensive while savings rates fall.[9]

Economic conditions such as inflation, unemployment, and GDP growth also affect interest rates. During recessions, rates often drop to encourage spending and investment. During periods of strong economic growth or rising inflation, rates may increase to prevent the economy from overheating. Understanding these broader trends may help you time major financial decisions such as refinancing loans or locking in CD rates.

Smart Moves for Managing Interest

Paying attention to the amount of interest you pay and earn may have an impact on your overall financial health. These practical strategies may help you minimize borrowing costs while maximizing savings returns.

Minimizing Interest On Loans

Whenever possible, pay more than the minimum payment on loans and credit cards, directing the extra funds toward the principal balance. When rates drop or your credit score improves, it may make sense to consider refinancing. For those carrying multiple debts, a debt paydown plan — such as the debt avalanche method (paying off highest-rate debt first) or the debt snowball method (smallest balances first) — may accelerate payoff.

Maximizing Interest On Savings

Shop around for high-yield savings accounts and CDs that offer competitive rates. When investing in CDs, CD laddering (splitting your money across CDs with different maturity dates) may help you capture higher rates while maintaining some liquidity. Automating transfers to savings accounts also helps improve consistency, which may help you build balances that earn more interest.

Comparing Financial Products

When comparing financial products, it’s important to look beyond the interest rate. For example, since the APR on loans and APY on savings accounts include the fees and compounding effects, these numbers give you a better picture of the true cost of borrowing or earning potential.

Watch for variables such as:

  • Introductory rates that change after a few months
  • Minimum balance requirements that could trigger fees
  • Early withdrawal penalties

Before committing, read the fine print to make sure you understand rate change policies on variable-rate products and any conditions that may affect your rate, such as autopay discounts or relationship banking benefits.

Making Interest Work for You

Understanding interest gives you more control over your finances, potentially helping you save money on loans and maximize returns on savings. With this knowledge, you can make informed decisions about everything from choosing the right savings account to timing major purchases.

If you’re looking to optimize your current accounts or explore new financial products, the professionals at PNC Bank are here to help. Contact us to schedule a personal appointment.