What Is Interest Income, and How Can You Earn It?
Do you like the idea of earning money without it depending on how much work you do? Interest income offers a realistic path to getting there.
April 5, 2022
This article is provided for informational purposes only and should not be construed as tax, legal or investment advice. Always consult with a professional financial, accounting or investment advisor before making investment decisions.
Working for a paycheck might be the most accessible way for the average person to earn money, but it’s certainly not the only way.
If you save your money and store it in the right places, interest income can give you extra cash flow and bring you closer to financial independence. But what exactly is interest income, and is it really possible to achieve in a world where many bank accounts are offering measly interest rates?
In a word, yes. To help you reach that point, we’ll run through an explanation of how interest income works, along with examples, and offer a few suggestions for how you can build it yourself.
What is interest income?
You can earn interest when you put your money into certain types of accounts or financial products. Many of us take interest-bearing accounts for granted, but they exist for a reason — when you provide capital, you’re offering a valuable service, so financial institutions compensate you for it.
For example, when you deposit your money into a bank account, you’re the lender, and the bank is the borrower. It’s the opposite process of taking out something like a personal loan, in which case you’re the borrower and pay interest expense to the bank.
However, there are many different types of interest income.
Examples of interest income
The simplest examples of interest income are accounts from financial institutions. These include:
Certificates of deposit
Money market deposit accounts
Distributions — also known as dividends — from credit unions or cooperatives
When you open one of these accounts, you’ll be signing up for a certain rate from the get-go, so you can estimate how much interest you’ll receive over a certain period. For example, if you open a certificate of deposit offering 1% interest for a year, and you put $1,000 into it, multiplying 0.01 by $1,000 shows that you’ll make $10 of interest income — assuming interest is paid once at the end of the year.
However, be aware that the rate you sign up for originally may not remain the same forever. Certificates of deposit usually have fixed rates over a certain time, but many other bank accounts have fluctuating rates.
Bonds are another option for interest income. Bonds involve you lending money to a government or business for a fixed period in return for interest income.
There are various kinds of bonds depending on who you’re lending to, including municipal bonds, treasury bonds, corporate bonds and U.S. savings bonds. Unlike the accounts outlined above, most bonds involve a degree of risk, so interest income isn’t always a guarantee.
You can also earn interest income from stock market investments, such as individual stocks, mutual funds and exchange-traded funds (ETFs). In this case, your interest income depends on the performance of the markets, so you can’t predict or calculate how much you’ll receive.
Interest income vs. investment income
Investment income is a broader term that includes not just interest income but also other types of revenue from investments.
For instance, you could invest in a property that appreciates in value and sell it at a higher value later; this is known as capital gains. Or maybe you could rent the property out to earn passive income.
In other words, interest income is a type of investment income, but not all sources of investment income are interest income.
Why build interest income?
The main reason to build interest income is the same reason we like to receive any kind of income — it gives you more money, which you can use for whatever purpose you please. However, this goes a little deeper than just having some spare cash to buy a new car or a pair of jeans.
If you manage to build up the amount you have saved or invested and increase the interest payments you receive, you could reach the point where you can live off interest. This means that the amount of interest you’re earning becomes so high that it removes the need for other sources of income, such as your salary from employment.
In the Financial Independence, Retire Early (FIRE) community, advocates build a retirement plan based on generating enough interest payments to cover all expenses. Let’s say you were lucky enough to have $1 million put away in a high-yield savings account paying 5% interest a year. You’d be earning about $50,000 a year in interest alone. It’s possible to live off of that money without having to eat away at your savings.
Although interest rates have been historically low since the financial crisis in 2008, it’s still possible to earn interest if you know where to look.
How to earn interest income
Onto the most “interest”-ing part: how to start earning income interest yourself.
Get financially secure
The first step is having enough spare money to put into places where it’s possible to earn interest. You may need to pay off debt to make this possible. It’s usually best to tackle things like credit card debt before you start getting serious about saving.
Choose your strategy
Then, you need to figure out the most strategic way to start earning interest income. The right choice for one person might not be the best option for someone else. You need to ask yourself how long you’re prepared to put the money away and how much risk you’re prepared to take on in return for the potential of more interest income — high risk usually means the chance for higher returns.
For example, treasury bonds involve little to no risk since they’re guaranteed by the U.S. government, but treasury bond interest is extremely low. In contrast, 100% equity ETFs carry a lot of risk but can offer impressive returns — younger people who don’t plan on using the money any time soon might consider it a worthwhile trade-off.
If you’re unsure where you stand, it’s always a good idea to speak to a financial advisor.
Once you start on the path of earning interest income, it’s going to take a while to get anywhere, so patience is key.
Over time, you’ll start seeing the benefit of compound interest, which happens when your interest starts to earn interest. For example, if you save $250 a month between the ages of 20 and 50, and it earned 5% interest, you’d end up with $208,064 — and more than half of that would be from interest rather than your savings.
How to report interest income
Interest income is a source of income, which means the Internal Revenue Service (IRS) may require you to pay taxes at your ordinary income tax rate.
In many cases, the entity or institution you earn interest from will send you a Form 1099-INT declaring how much interest you were paid — similar to how your employer sends you a W-2 for your salary. You will then report the interest income on your income tax return. If you earn more than $1,500 in taxable interest, you’ll need to file a Schedule B.
Keep in mind that not all interest income is taxable. Some government bonds may have their own special tax protocols or are only partially taxable. For example, you don’t have to pay tax on interest from municipal bonds unless the alternative minimum tax applies to you. You also don’t need to worry about anything earned in a Roth IRA or other similar accounts where earnings aren’t taxable.
If you have any doubts, make sure you check with an accounting professional at the end of the tax year because the details can get complex.
Are you interested?
There are many different ways to earn interest income, and there’s something for all risk appetites and time horizons. Once you get into the mentality that you can earn income by letting your money work for you and not just by working for your boss, a whole new world of possibilities opens up.
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