Key insights:
- Interest rates represent either the cost of borrowing or the return on savings and higher rates can lead to greater costs or earnings
- Annual percentage rate (APR) and annual percentage yield (APY) are helpful for comparing financial products
- Simple interest is calculated only on the principal, while compound interest includes previously earned interest in its calculations
- Fixed interest rates provide predictability, while variable rates can fluctuate
When it comes to personal finance, some key terms are worth knowing. Interest rates are common terms in banking products like savings accounts, so it’s essential to understand what they are and how they work before borrowing or depositing funds.
Let’s dig deeper into the different types of interest rates, as well as how to calculate interest on savings.
What is an interest rate? Key terms explained
Simply put, an interest rate is either the amount you pay to borrow money from a lender, or the rate of return that’s paid to you on an interest-bearing account, such as a savings account or certificate of deposit (CD). The higher the interest rate, the more you’ll pay, or be paid, in interest and vice versa.
There are a few common ways to recognize and calculate interest rates.
| Type of Interest Rate | Definition | Common Banking Products |
|---|---|---|
| Simple | Interest calculated only on the original amount of money you borrow or deposit. | Personal loans, certain promotional deposit accounts |
| Compound | Interest calculated on the initial principal and the accumulated interest from past periods. | Savings accounts, high-yield savings accounts, money market accounts, most CDs |
| Annual percentage rate (APR) | The total yearly cost to borrow money, which includes the base interest rate plus any loan fees. | Credit cards, mortgages, auto loans, personal loans |
| Annual percentage yield (APY) | The actual amount of interest you earn on an account in a year, which factors in the effect of compounding. | Savings accounts, money market accounts, CDs |
| Fixed | A rate that stays the exact same throughout the entire lifespan of the loan or deposit product. | Fixed-rate mortgages, fixed-rate CDs, some personal loans |
| Variable | A rate that moves up or down over time based on broader market conditions or a specific benchmark index. | Credit cards with variable rates, some savings and money market accounts |
Simple interest vs. compound interest
An interest rate may be either simple or compound.
- Simple interest accrues based solely on the principal balance (the original amount of your loan or deposit)
- Compound interest on deposit accounts accrues based on both the principal and the earned interest
Compound interest accumulates faster than simple interest. When it comes to savings accounts, compound interest means you can earn more, faster. Meanwhile, simple interest would be favorable on loans or credit.
Interest may be compounded daily, monthly, quarterly, semi-annually or annually. For savings accounts, the more compounding periods within a year, the higher the return.
APR vs. APY
The interest rate on a loan or savings account is a useful benchmark for understanding costs and benefits. However, there are 2 common ways of expressing the interest rate in a more meaningful way:
- Annual percentage rate (APR): This varies slightly from the interest rate when you borrow money because it includes the interest rate plus fees. APR is typically used for loans or credit.
- Annual percentage yield (APY): This rate explains how much your money can make in a given year when you deposit funds in an interest-bearing account. APY is based on the interest rate, but it also accounts for compound interest to give you a clearer picture of what you might earn.
The APY and APR can be useful information when comparing accounts and loans more accurately.
Fixed interest vs. variable interest
Interest rates can also be either fixed or variable.
- Fixed interest rates stay the same throughout the term of the product, such as a loan or CD. That means it’s easier to predict how much you’ll pay or earn in interest over a given period.
- Variable interest rates can change over time. These are often tied to an index, such as the prime rate. When rates change, your interest rate may change as well. Variable rates may be offered on credit cards, loans and savings accounts.
While fixed interest rates can provide predictability (in costs or earnings), variable interest rates generally carry more risk, as well as the potential for savings. For example, if your loan variable interest rate goes down, you can save money on interest. However, if it goes up, you may end up paying more overall.
How does savings interest work?
Savings interest is usually calculated using either simple interest or compound interest, depending on the type of savings account you choose. Let’s take a look at how each type of interest works.
Simple interest on a savings account
The formula for simple interest is as follows:
Interest = P x r x t
- Principal (P): The initial amount of money deposited
- Rate (r): The annual interest rate expressed as a decimal
- Time (t): The length of time the money is deposited, in years
Say you deposit $1,000 in a savings account with a 5% annual interest rate for 3 years:
Interest = 1,000 x 0.05 x 3 = $150
Using this formula, you can calculate that you’d earn $150 on your savings after 3 years, for a total of $1,150.
Compound interest on a savings account
The formula for compound interest is as follows:
A = P(1 + r/n)^(nt)
- P: The principal (initial) amount of money deposited
- r: The annual interest rate expressed as a decimal
- t: The length of time the money is deposited, in years
- n: The number of times interest is compounded per year
- A: the future amount you will have in total (principal + interest)
Calculating this formula using the same example above (an initial deposit of $1,000 in a savings account with a 5% annual interest rate for 3 years) and compounded yearly, you’d earn $157.63, for a total savings of $1,157.63.
With no additional contributions, the compounded interest savings account grows faster because interest is earned on both your principal and previously earned interest.
Compare interest rates and maximize your savings with Citi
Interest rates can seem complicated at first. Once you understand how they work, you can begin finding products and accounts that meet your needs. Before opening a savings account, review the account disclosures to understand how interest compounds. You can also use a compound interest calculator to estimate how much you could earn.
Citi offers both savings and CD accounts with different terms, balance ranges and rates to choose from. You can also take advantage of Citi’s banking features like Spend & Save to round up purchases and add the surplus funds to your savings.
Ready to maximize your savings? Explore and compare interest rates on Citi® Savings Accounts and CDs today.
*Rate provided is for illustrative purposes only.
Disclosure: This article is for general educational purposes. It is not intended to provide financial advice. It also is not intended to completely describe any Citi product or service. You should refer to the terms and conditions financial institutions provide for various products.
