by Maja Majewski

Commonly Used Banking Terms: Interest Rates Edition

Interest, APR, APY, oh my! If you’ve ever been confused by these commonly used banking terms, you aren’t alone. Here, we break down all the terms commonly associated with interest rates so you can make the best financial decisions for your life.
banky terms

It’s not surprising that many Americans are a little fuzzy on banking lingo: Most of us never had a single personal finance class in school! To make things even more confusing, the banking industry is notorious for using lots of jargon and acronyms, making it hard to know what’s what.

We’re on a mission to help people feel more confident with their money. Toward that goal, we’re here to demystify many of the banking terms you’ll need to know to level up your personal finance game. Here are the commonly used banking terms you’ll see around interest rates.

Interest 101

First things first: What is interest, anyway? You can think of interest as the cost of borrowing money. In some situations, you’ll be the one borrowing money (like if you take out student loans or accumulate credit card debt and have to pay it back). In others, you’ll be the one lending money—like if you keep your money in a bank (more on this later!)

Interest: The cost of borrowing money. When you borrow money, you pay interest. When you lend money, you earn interest (aka using a savings or CD account, which we’ll get into more below!).

Paying Interest

If you have any kind of debt—credit card, student loans, a car, a mortgage—you’re probably familiar with the idea of paying interest. Unlike interest you earn on money you have, this is the interest you pay on money you’ve borrowed.

It is possible to save money and earn interest while paying off debt (and reducing the amount of interest you’re paying in the long term). You can learn how here.

For the rest of this post, we’ll be talking about common terms about interest you can earn on the money you save.

Earning Interest: Simple vs. Compounding

You might not think of yourself as a ‘lender’ of money, but you probably are! When you deposit money into a bank or credit union, you’re essentially loaning it to them. The bank will invest your money and use it for other sorts of transactions. To say thanks, banks will pay you interest for keeping your money in the account.

When you check your balance, the money will appear to be right there, but really, it’s hard at work doing other things behind the scenes. (But don’t worry—if it’s in a Simple account, it’s insured up to the legal limit by the FDIC.)

There are two kinds of interest you could be earning on your account: simple and compounding. It’s important to know what kind of interest you’re earning on your money, so you can know what amount of money to be able to count on in the future. How much you have in your account - your principal balance - will affect how much interest you earn, so let’s define that first.

Principal Balance

Principal balance: The amount of money you put into your account, minus any interest earned on that money.

The total amount of money you put into an account = principal balance

The money you put into your account is called your principal balance. It’s important to know because this is what determines the interest that you’ll earn on your money. Sometimes, the higher the balance, the more you earn—but if you don’t have a high balance to start out with (most Americans don’t), you might not qualify for the advertised interest rates. Double-check minimum balance requirements, to make sure that you’re earning as much as you can on your balance.

TIP: Wherever you’re an account holder, pay attention to the interest rate you’re earning - and if it’s a variable rate product (we’ll define that below), pay attention to rate changes so you know how much you’re earning.

There are two kinds of interest you could be earning on your account: simple and compounding. It’s important to know what kind of interest you’re earning on your money, so you can know what amount of money to be able to count on in the future.

Simple Interest

Not to be confused with Simple (as in, like, us Simple), simple interest is the money that you earn on your principal balance, but not on any of the interest that you’ve already earned.

Here’s a simple way to calculate simple interest:

Principal balance X the interest rate = simple interest

For example, let’s say you have $5,000 as your principal balance in your account and your interest rate is 2.00%. Over the course of a year, your account will earn $5,000 x 2.00% = $100 in interest, for a total of $5,100 in your account. Assuming that you don’t make any other withdrawals or deposits, the next year you’ll earn $100 again, and so on.

Compounding Interest

Earning simple interest is awesome (free money!)—but earning compounding interest is even better. With compounding interest, you’re earning interest on your entire account balance.

Principal balance PLUS any interest you’ve earned on it X the interest rate = compounding interest

That means if you’ve already earned interest on money in that account, you will earn interest on both the principal balance and previously-earned interest. Over time, the interest you earn on your balance could even exceed the principal balance!

Let’s take the same example from above. You’re earning 2.00% interest compounded monthly on a principal balance of $5,000. The formula here is a little more complicated but what it means is that at the end of the year you would have $5,100.93 instead of $5,100. Even though for now it’s a difference of just under $1, as the account balance grows, so does the overall interest you’re earning.

image2 Example above is for illustrative purposes only. Calculations assume an initial deposit of $5,000 that remains on deposit for the terms above and no withdrawals or deposits were made on the account. The calculation also assumes the 2.00% interest rate and 2.02% APY does not change from initial deposit through the end of Year 30.

Over a longer period of time, compounding interest has an even bigger impact. Over 10 years, you’d earn $1,106.02 instead of $1,000 (over $100 more!), and over 30 years, you’d earn $4,106.04 in interest instead of just $3,000—just for keeping your money in an account that earns compounding interest.

A Note About Compounding Schedules

A compounding schedule—how often your interest ‘payout’ gets calculated—is super important too. The example above was compounded monthly. The more often it’s compounded, the more money you’re potentially earning. So if you’re looking at rates, check to see how often the interest is actually being calculated.

TIP: If you want to earn compounding interest on your money, check to see how often the interest is being compounded. You’ll earn more if your balance is compounded monthly (12 times a year) instead of yearly (once a year).

If access to the interest you earn is important to you, be sure to learn when your account will be credited too—that’s when the money will actually hit your account.

(FYI: Simple Protected Goals Accounts are compounded and credited monthly, so you can grow your money faster.)

Understanding APY

Ok, so now that we’ve talked about interest and power of compounding, let’s dive into APY, which will be key in helping you choose the right type of account for you.

APY (Annual Percentage Yield): The acronym stands for Annual Percentage Yield and it’s basically the total amount your account will grow in a year (including compounding interest) expressed as a percentage, e.g. 1.01%.

If you’re trying to grow your money, you’ll want to find accounts with competitive APYs. APY rates vary from one financial institution to the next, and a lot of factors go into determining the rate. Some include: risk, financial standing of the institution, market competition, overall market conditions, and the federal interest rates.

Comparing interest rates: What to look for

When you’re shopping around for the best rate (for a high-yield checking account, certificate of deposit, or other interest-bearing account), make sure to compare the APY, not just the interest rate. APY is the only reliable number that allows shoppers to compare rates because by law, it has to be calculated the same way across the industry.

TIP: Choose an account with a high APY so you can earn the most money on your money!

Competitive APY

The higher the number, the better, of course. But be sure to read the fine print: There are often requirements that you have to meet in order to earn high interest rates.

No deposit requirements or minimum balance requirements

When comparing interest-bearing accounts, be sure to look into how interest rates change based on how much you have in the account. Many types of accounts require you to have and maintain a minimum balance before you can start earning interest, or to qualify for the high interest rates they advertise.

For example, if there is a minimum balance requirement of $5,000 to earn the 2.00% APY, you will not be earning that 2.00% APY unless you have and maintain at least $5,000 in that account. If that rate suddenly dips to below 0.50% APY if you don’t have the minimum balance, that’s something you’ll want to know! You might be better off keeping your money in an account that earns 0.60-1.99% APY in the meantime so that you can grow it faster.

If the account you’re considering requires a minimum balance that you don’t think you’ll be able to maintain, shop around for an account without a minimum balance requirement. You can always transfer your money into a different type of account once you’ve built it up.

Some accounts (like Simple’s high-interest checking accounts) have a tiered interest rate, where you can earn a higher rate as your balance grows. This is a great option if you’re looking for a ‘set it and forget it’ approach to growing your money!

No balance caps

Another thing to look out for is balance caps—that’s when the high interest rate is only good for money up to a certain balance, then you might earn a lower interest rate for balances above that threshold. If you’re wanting to put money into an account and just let it grow there–make sure you’re putting it somewhere that it can continue to grow over time.

TIP: Make sure the accounts you’re considering don’t have balance caps that would affect your ability to grow your money in the future.

Fixed vs. Variable Rates

Another thing to consider when comparing interest rates is whether the rate is variable or fixed: Whether you can expect it to stay constant or change over time.

Most types of accounts that allow you to earn interest on your balance will have variable rates. This is because of how our banking system is structured: Basically, rates are determined by the US central bank (or “The Fed”) as a way to maintain the health of the economy. The Fed will increase or decrease the fed funds rate (which then determines the rates of financial tools with variable rates) based on the supply of money and inflation. Banks offer variable rate products in order to have the flexibility to keep up with the Fed’s rate changes and maintain a sustainable business.

Variable rate: A rate that can change any time after you open an account. There are all sorts of reasons a rate can change. Rates might change based on the economy or to remain competitive within the industry.

Fixed rate: *The opposite of a variable rate, a fixed rate is when an interest rate doesn’t change. *

There are some ways to secure a fixed rate on an interest rate, though, which can be a risk-free way to guarantee that your money will grow over time. This is great for money you really want to hold onto for those bigger short and long term goals.

A Certificate of Deposit is one example of a fixed rate financial tool that can help you earn a fixed interest rate over time. Certificates of Deposit typically offer a higher APY because you’re agreeing to hold your money in the CD for a set period of time. Once you lock in your term and interest rate, it won’t change, even if interest rates are going down elsewhere.

Simple recently started offering CDs. If you’re interested in growing your money with a Certificate of Deposit, learn more here!

Keep Learning

We hope this post has demystified some of the commonly used banking terms around interest rates. When it comes to personal finance (and life, really), knowledge is power. Listen to personal finance podcasts, follow us on social media, and leave us a note if there’s a topic you’d like to learn more about!

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