A Guide to Interest Rates

When it comes to your finances, interest rates are actually a pretty interesting topic — especially when they help your money grow. A little interest can go a long way towards saving for a dream vacation, a down payment on a house or a remodel of your current place.

You might be wondering what the best savings account rates are or how interest is paid. You might also have questions about interest earned or interest paid.

If you'd like to learn a little bit more about interest rates and how they can work for you, you're in the right place. This guide will help you make sense of interest rates, inflation and more.

What is an interest rate?

When you save money for the future by opening a savings account, the account's interest rate is the rate your bank pays you for keeping your money with them. The money you earn on your savings is, naturally, the interest.

In contrast, if you borrow money — say to pay for a house or car — the interest is the fee you pay a lender for using their money over a period of time. When the loan is fully repaid, you will have paid the lender interest in addition to the original amount you borrowed (commonly referred to as the principal). The rate for your loan will indicate how much interest you will pay each month. The annual percentage rate (APR) will indicate the total interest over that year.

In a nutshell, it costs to borrow money and it pays to save. To learn more about different types of rates and how they are calculated, read on.

Calculating interest rates for saving

Interest works in your favor when you save. By earning interest on your deposits, you can increase the amount of money you end up with at the end of the saving period. Therefore, to better plan your savings goals, it helps to know how to calculate interest.

For example, if an emergency cash stash of $2,000 is deposited into a high-yield savings account that offers a 2% APY. After one year, assuming no withdrawals or deposits, the interest earned will amount to $40. The new savings total: $2,040.

Adding to your initial balance every month can allow you to use the interest to grow your savings even more. If you add just $100 each month to the account, your annual interest earnings will increase to $53.

The savings total:
= opening balance + total monthly contributions + annual interest
= $2000 + $1,200 + $53
= $3,253

Simple interest vs. compound interest: What's the difference?

You'll want to know if the interest on your deposits and loans is simple or compound. Simple interest is calculated on the principal (original) amount of a loan. Compound interest on a deposit means each time the interest amount is calculated and added to the account, the cumulative balance earns interest. Bottom line: with compounding you earn interest on both your original money and on the interest the bank pays you each period to keep money in the account.

It's important to find out how frequently interest is compounded for your savings account or loan: daily, weekly, monthly, semi-annually or annually. For a given annual rate on a savings account, the more compounding periods within a year, the higher your annual interest earnings will be. On a loan, more compounding periods in a year means the total amount you pay in interest will be higher that year.

Interest for high-yield savings accounts is typically compounded daily. In the example above, the interest was calculated using daily compounding.

To see how this works, check out the table below:

  Opening Balance Interest Rate: 3%* Closing Balance
Year 1 $5,000 $152 $5,152
Year 2 $5,152 $157 $5,309
Year 3 $5,309 $162 $5,471
Year 4 $5,471 $166 $5,637
Year 5 $5,637 $171 $5,809
Year 6 $5.809 $177 $5,986

*3% interest compounded daily - interest is calculated on the principal amount plus the interest earned for 365 days.

Types of interest rates

We will transition from numbers to letters when it comes to different types of interest rates. These terms are important when it comes time to open a savings account or take out a loan, so we'll walk you through the differences:

  • Annual Percentage Yield (APY): This rate explains how much your money can make in a given year when you deposit funds in a savings account, Certificate of Deposit (CD) or other interest-bearing account. APY is based on the interest rate, but it also includes compound interest to give you a clearer picture of what you might earn.
  • Annual Percentage Rate (APR): This varies slightly from the actual interest rate when you borrow money because it includes the interest rate plus fees.

The main thing to remember is these rates can help you make comparisons between various options when it comes to a savings account or loan.

Interest earned vs. interest paid

Interest earned accumulates through setting aside money in a savings account and taking advantage of interest, while interest paid is the total interest you will pay over the life of your loan.

Of course, interest earned is ideal. Interest paid can be a mixed bag.

For instance, if your mortgage or student loan interest rate is relatively low, you might be earning more with your savings and investments than you are paying towards your loans each month, all while building your credit history.

On the other hand, high credit card interest rates might exceed your savings interest rate if you're not paying balances in full and carrying multiple cards. Pay attention to your statements and take the time to read the fine print.

What to look out for with interest rates

When opening up a savings account, take a look at ATM options, what the bank charges for overdrafts and requirements for a minimum balance. Consider a high-yield savings account with a higher interest rate for bigger savings. When you're borrowing money, look at the interest rate and any fees.

If you have questions, contact a branch representative, financial advisor or accountant for more information on how interest rates may impact your current and future financial situation.

Interest can help you achieve your financial goals, enhance your savings and reduce your time until retirement. When interest works for you, you earn interest on interest and build wealth.

You can view Citi's latest interest rates for checking and savings accounts, CDs, IRAs, personal loans and lines or credit, mortgages and more.

Disclosure: This article is for educational purposes about banking products. It is not intended to provide legal, investment, tax, or financial advice and is not a substitute for professional advice. It does not indicate the availability of any Citi product or service. For advice about your specific circumstances, you should refer to the disclosures financial institutions provide for various products and consult a qualified professional.

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