Published June 27, 2024

What Is an Interest Rate?

Simply put, an interest rate is the cost of borrowing money or the reward for saving it. Imagine you’re lending money to a friend; you'd probably expect something extra in return, right? That extra bit is essentially the interest.

Example #1: Savings Account — When Interest is Your Friend

So, you've decided to stash some cash in a savings account. Great move! Banks love this because they can use your money to lend to others. To sweeten the deal for you, they’ll pay you a bit of interest on your deposited amount.

Picture this: You put $1,000 into a savings account with an interest rate of 2% per year. By the year’s end, you’ll have earned $20 just for letting your money chill in the bank. That might cover a couple of fancy coffee dates or maybe even a new book you’ve been eyeing. Not too shabby, huh?

Example #2: Credit Card — When Interest is the Villain

Now, flip the script. You’re using a credit card, essentially borrowing money from the bank whenever you swipe. If you pay off your balance in full each month, awesome! You dodge any interest charges. But if you carry a balance, watch out.

Say you have a $1,000 balance on a credit card with an interest rate of 18% per year. If you only make minimum payments, the interest adds up fast. Instead of buying you coffee, those interest charges start to feel more like an unwanted guest who won’t leave. You could be looking at around $180 in interest charges if you don’t pay down the debt quickly. Not so fun anymore, right?

Why Do Banks Pay You Interest?

You might wonder why banks are willing to pay you to keep your money there. The answer’s pretty simple: they use your deposit to fund loans to other customers. Your savings help someone else get a mortgage, a student loan, or a small business loan. Banks earn interest from these loans, a bit of which they pass on to you as a thank-you for your deposit.

So, next time you’re sipping that coffee paid for by your savings account interest, you’ll know your money’s been hard at work, making the world go round!

And there you have it, a quick guide to understanding the highs and lows of interest rates. Whether you’re earning it or paying it, knowing how interest works can help you make smarter financial moves.

If you want to take control of your finances and get a handle on where your money goes each month, Latwy offers a free 30-day trial.

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