How Does Interest Work?

Interest is money that may be paid as one of the costs of borrowing on a loan or credit card, or earned from an interest-bearing deposit account or investment. Understanding how interest works, particularly across different types of accounts, can help you make the most of your savings and investments while minimizing your costs when borrowing money.

Simple vs. Compound Interest

There are two different ways financial institutions can apply interest. With simple interest, the interest rate is applied only to the principal balance or investment amount. This type of interest is typically used with installment loans and investments.

In contrast, compound interest accrues based on the principal balance and any interest that’s accrued since the last payment. Compound interest is commonly used for credit cards and deposit accounts. Additionally, you can earn compound interest on an investment by reinvesting the interest or dividend income you receive.

How Do Lenders Determine Interest Rates?

There are a few different factors that lenders consider when determining interest rates on credit cards and loans:

• Risk-based pricing: Lenders typically use risk-based pricing, which means that your interest rate is largely determined by your creditworthiness—or the likelihood that you’ll pay back the amount borrowed on time.
• Market rates: Lenders also typically use a benchmark rate, such as the Wall Street Journal prime rate, to help determine loan rates.
• Lender policies: Each lender has its own approach to determining interest rates based on its financial profile and strategic objectives.

Pros and Cons of Paying Interest

Paying interest isn’t always ideal, but there can be some benefits to using credit. That said, there can be some significant drawbacks, especially with high-interest credit products.

Pros

• It allows you to finance large purchases.
• You can leverage your money.

Cons

• Some credit products are expensive.
• Interest can cause your balance to increase.

Pros and Cons of Earning Interest

Putting money in a savings or investment account can help you generate a return on your balance, but it isn’t always the most effective way to use your cash.

Pros

• You can earn passive income.
• You could generate returns in other ways.

Cons

• Not all opportunities are created equal.
• Some options carry risks.

How to Avoid Interest Charges

The best way to avoid paying interest entirely is to never borrow money. But that’s not feasible for many people, so it’s important to know how to minimize your interest costs. Here are some steps you can take:

• Establish good credit.
• Avoid unnecessary credit.
• Avoid overborrowing.
• Opt for shorter loan terms.
• Pay your credit cards in full.

Monitor Your Credit to Maintain Low Interest Rates

Building credit is crucial to helping you qualify for favorable interest rates. But once you reach a good level with your credit score, it’s important to avoid getting complacent. Otherwise, you could miss some problems that can wreak havoc on your credit history.

The good news is that you don’t necessarily have to check your credit score and report constantly to stay on top of your credit. Experian’s free credit monitoring service offers alerts when new information, such as inquiries, new accounts, and personal information, gets added to your credit report.

As you stay on top of your credit through alerts and checking occasionally, you’ll be in a better position to maintain the result of all of your hard work.