Interest Rate Basics

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Albert Einstein once claimed that the most powerful force in the universe is compound interest. That is impressive praise coming from the person whose work helped revolutionize physics. While interest can be powerful, it can also be complicated. Read on to learn what interest is and how it can affect your life today and in the future.

1) Interest that you pay on the money you borrow.

When you borrow money from a financial institution — in the form of a personal loan or a mortgage, for example — you pay back more than the amount you borrowed. Your monthly payments consists of both principal and interest. The principal is the amount you borrowed. The interest is the cost to you of borrowing the money, paid as a percentage of the principal amount. Annual Percentage Rate (APR) is the total cost of borrowing (interest plus other items such as fees), expressed as a percentage of the amount borrowed, applied each year.

Most borrowers pay off loans gradually over time. The sooner you pay back a loan, the less you will pay in interest. For example, if you make an extra payment each month, it reduces the amount of interest you pay over the life of the loan and helps you pay off the loan sooner.

When you are looking to borrow money, it may be to your advantage to find a low interest rate (or APR), so you will pay less in interest over time and have lower monthly payments.

2) Interest that you earn on the money you deposit.

Another type of interest or dividend is that which you earn on your money. When you deposit money into a savings, certificate, or money market account, your financial institution pays you money, in the form of interest or dividends for keeping your money in an account with the financial institution. Annual Percentage Yield (APY) indicates the total amount of interest or dividend you will earn in a year on your deposited money if you do not withdraw it. APY takes into account how often (e.g., monthly, quarterly) interest or dividend is added to your deposit balance in a year. As the interest or dividend you earn is added to your deposit balance, you will earn interest or dividend on the previous interest or dividend posted. This is called compound interest.

When you are looking to invest your savings into an account, you want a high interest or dividend rate (or APY) to earn the most on your investment.

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