What You Should Know About Different Types of Interest Rates
The types of interest rates you see in an interest-bearing account can strongly influence where you decide to keep your money.
Contributing Writer at Tally
November 16, 2021
If you're stashing money away as part of your short- or long-term financial goals, you may want to consider the different types of savings accounts available. When weighing the pros and cons between these options, it's important to pay attention to the interest rate, often expressed as the annual percentage yield (APY).
Learn more below about what interest is, the different types of interest rates and the impact interest has on interest-bearing accounts — especially when compared to loans and credit cards.
What is interest?
Interest can mean one of two things:
What financial institutions like banks or credit unions pay you to store your money with them.
The cost of borrowing money from a lender.
For the purposes of this article, let’s focus on the first definition, though we'll explain the differences between the two in a bit.
Banks and credit unions pay you to keep your money in their accounts. Your funds allow them to pay for overhead expenses like rent and utilities and allow them to invest in marketing and advertising campaigns that draw other customers in.
In exchange for you keeping your money in their accounts, these institutions pay you a certain amount of money each month. This amount of money is known as an interest payment.
What does "interest-bearing" mean?
"Interest-bearing" is a term used to describe accounts that make interest payments to you. Investment accounts aren't typically considered interest-bearing, since your payments aren’t fixed. The amount of money you earn in investments depends on what you invest in and the state of the market. Essentially, you subject yourself to market fluctuations when investing.
Interest-bearing accounts are inherently safer. They provide you with a stable place to keep your money and that money is liquid, meaning you can convert it easily to cash.
Interest-bearing accounts are also insured. Though it's worth double-checking, a good majority of banks are FDIC-Insured, while credit unions are NCUA-insured. In both cases, up to $250,000 in assets are protected if your financial institution were to go under. So, even though the financial institution may be using your funds, you still have immediate access to your money.
A few types of interest-bearing accounts include:
The amount you can earn by leaving your money in one of these accounts depends on three things:
The interest rate (the higher, the better)
The total balance (the higher, the better)
The period of time you leave the money in the account (the longer, the better)
You can conduct interest calculations online to see how much you can earn by leaving your money in an interest-bearing account.
How is interest-bearing different from the interest rate on a credit card?
When you put your money in an interest-bearing account, you're earning money. When you borrow money from a lender, that lender charges you a fee. That fee is known as the interest rate. The amount of interest you owe is based both on your rate and the principal amount you borrowed.
Not only does this apply to credit cards, it also applies to different types of loans, including:
There are a few extra differences to note between the two. For one, your credit history likely doesn't impact the interest rate you receive on an interest-bearing account. These rates are based on the Federal Funds Rate.
The interest rates on borrowed money, however, depend on your credit history and score. If you have a good credit score, there's a stronger chance you'll receive a lower interest rate.
Additionally, you may see interest rates expressed as annual percentage rates (APRs) or annual percentage yields (APYs).
APRs are an expression of simple interest. They're commonly seen with regard to borrowed money since lenders don't necessarily want to reveal the total cost of you borrowing from them. APRs reflect your monthly payment but don't reflect what happens if you fall behind on repayment and your principal balance increases. Essentially, APRs don't express compound interest, which ultimately increases the total interest you owe. Though the rates may seem lower, they can result in high-interest debt.
APYs do factor in compounding interest, so they’re an expression of a year's interest earnings. APYs typically reflect higher interest rates than APRs since financial institutions want to entice you to leave your money with them.
What are the different types of interest rates on interest-bearing accounts?
Now that you have a high-level understanding of interest, here’s a closer look at the different types of interest you may see in an interest-bearing account.
Simple interest is based on the initial principal amount of your deposit. Your monthly interest payouts are the same every period unless your interest rate were to change.
For instance, let's say you put $5,000 into an account that yields simple interest. The interest rate is 3%, which means you would earn $150 per year or $12.50 per month.
You'll earn this $12.50 consistently. Even though your balance is $5,012.50 after the first month, your future calculations are based on the principal balance. Your principal balance can change based on money you put in or pull out, but previously paid interest isn't factored in when calculating future interest.
Compound interest, on the other hand, is reflective of your entire balance. Using the example above, your balance after the first month is $5,012.50. Then — assuming your interest compounds monthly — your next interest payment is calculated with this balance. Your interest payment after the second month is $12.53, a bit higher than it was with a simple interest rate. Your new balance is $5,025.03.
At the end of the first year, your balance is $5,152.08. You'll have earned an extra $2.08 in interest because your interest rate compounded. This may not seem like a lot, but it adds up over time. Compounding interest is critical to maximizing growth and building wealth.
A fixed interest rate does not change. Certificates of deposit are examples of interest-bearing accounts with fixed interest rates. You lock yourself into a rate for a pre-defined period of time. No matter whether the Federal Funds Rate goes up or down, your interest rate won't change. This allows you to budget and plan ahead since you'll know exactly how much you'll earn in interest.
Variable interest rates can fluctuate. The rate you receive when you open the account can change based on the Federal Funds Rate or the balances you have in the account, though this can vary from bank to bank. If the rate lowers to something that's below your liking, you can pull your money and deposit it elsewhere.
As discussed previously, there are annual percentage rates and annual percentage yields. Annual percentage rates reflect simple interest, commonly seen when borrowing money. Annual percentage yields reflect compounding interest and are commonly seen when depositing money.
Start saving today to improve your financial situation
When determining where to put your savings, something to strongly consider is the interest rate. Interest rates on savings accounts are different from the types of interest rates you see on your credit card or home loan. Knowing the nuances between the two can help you maximize your earnings.
If you're looking for more financial insights, you can sign up for a complimentary email newsletter from Tally†. Tally’s personal financial newsletter is delivered straight to your inbox and covers a wide range of topics — from interest rates to debt consolidation and much more.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.