What Is an Interest Rate?

Oct 07, 2025

When it comes to your finances, some things are hard to avoid. Interest rates fall into that category, so it’s important to understand how they work.

Simply put, an interest rate is either the amount you pay to borrow money from a lender, or it’s the rate of return that’s paid to you on an interest-bearing account, such as a savings account or CD. The higher the interest rate, the more you’ll pay, or be paid, in interest, and vice versa.

Let’s dig deeper into how interest rates work, including what annual percentage rate (APR), annual percentage yield (APY), simple and compound interest are, as well as how to calculate interest on savings accounts.

What are interest rates? Key terms explained

There are a few common ways to categorize and calculate interest rates.

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:

  • APY: This rate explains how much your money can make in a given year when you deposit funds in a savings account, CD or other 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.
  • 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.

The APY and APR can be useful info when comparing accounts and loans more accurately.

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 balance on your account)
  • 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.

Fixed interest vs. variable interest

Interest rates can also be either fixed or variable.

  • Fixed interest rates stay the same throughout the life 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 also change. Variable rates may come with credit cards or loans, as well as savings accounts.

While fixed interest rates can provide predictability (in cost or earnings), variable interest rates generally carry more risk, as well as the opportunity for potential 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.

Calculating interest rates for savings accounts

The amount you’ll earn in interest on a savings account depends on your APY. Let’s say you deposit your emergency fund of $2,000 into a savings account that offers a 2% APY. After one year, assuming you don’t withdraw or deposit any funds, and the interest rate doesn’t change, you will earn $40 in interest.

This calculation assumes that the account compounds interest annually. Your account may compound interest more frequently, which can require a more complicated way to calculate savings account interest. However, the APY does account for compounding, while the raw interest rate does not.

If you only have your interest rate, for example, and your savings account compounds interest daily, you’d need to:

  • Divide the interest rate by the number of days in a year
  • Multiply that rate by your starting balance
  • Add that earned interest to your previous balance
  • Multiply the daily rate by that combined amount
  • Repeat that process for the full year

Interest rates can be complicated. Once you understand how they work, however, you may begin to find products and accounts that meet your needs.

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.

Additional Resources

  • Citi Financial Pathways

     

    Utilize these resources to help you assess your current finances & plan for the future.

  • FICO® Score

     

    Learn how FICO® Scores are determined, why they matter and more.

  • Glossary

     

    Review financial terms & definitions to help you better understand credit & finances.

Important Information