Albert Einstein once supposedly said that (compounding) interest is the 8th wonder of the world. Whether that wonder is working for you, or against you, will make it your friend or enemy.

The interest rate, sometimes just called interest, is a percentage of a whole that is paid by one party, for allowing another party to use it.

Interest working for you

Consider a savings account. When you put your money in the bank to “save it”, the bank is going to not just lock it up in a vault. They put that money to work. Because you let them use that money, they pay your a portion of what you put in back extra.

For simple numbers, let’s say that amount was 5%, and you put in $100. At the end of a time period, like a quarter, you’d have that $100, plus an additional 5%, or $5, or a total of $105. At the end of the next quarter, you’d have another 5%, but instead of it being on $100, it’s on $105. That means you’d get an extra $5.25. Now your total is $110.25.

At the end of every period your bank account increases. At the end of four quarters, one year, you’d have $121.55. That is assuming you don’t add any extra money (deposit), or take out (withdraw) from the account during that year.

Your money is literally making money.

Interest working against you

Now why does the bank give you money for putting it in a savings account? Well, that’s because of how it uses it. It will take your money, and the money of other people, and loan it out. So let’s say you wanted to buy a car. They go to the bank, and get a loan for $30,000 and the bank is going to charge you interest to use their money.

For simplicity sake, let’s say it’s 10%. If you doesn’t pay off the loan, the loan amount will be $33,000 at the end of the year. Now, each month the bank will want you to pay down that loan, so you’ll pay a little bit in interest and a little bit in the principle – the amount that they borrowed.

The amount you pay will depend upon how long the loan is for and how much they actually borrowed. In a normal loan situation, you will always pay the interest plus some principle for a given year/quarter/month/etc.

Car loans tend to be for between four and six years now a days, while a home mortgage will be for between ten and forty years. Most of the time it is fifteen or thirty.

Why different interest rates?

The rate that the bank gives you on an account will typically be the same as they give anyone else. Sometimes they will give higher rates to people to put a lot of money in the bank (the banks rewarding them for putting extra money into them so they can make money off of it), but generally you have to have a very large deposit amount to make that higher interest rate ($50,000 to $100,000 or more).

You will also notice that you pay a higher interest rate to borrow money than when you put it in the bank – why is that? Well, the bank has certain overhead cost they have to pay. Everything from the teller who takes your money, to the loan officer who gives you the money you are borrowing, to the buildings that they are in, etc. There are a lot of people and items that have to be paid.

Additionally, the bank knows that some people, despite their best intentions (or not) will not pay back all of the money lent to them, and the bank could lose money in the deal. They have to make sure they cover those potential losses.

How to get a better interest rate when you borrow

The interest you pay on a loan however will vary greatly and are based on a couple of factors.

First is your credit worthiness. Your FICO score will tell a lender how much of a risk you are. i.e. does the bank think you can pay the loan back. A low score is a low confidence, and the lender (bank) will charge you a higher interest rate to cover cases where you might skip town without paying.

Second is what is the loan for. House mortgages tend to be cheaper than most other loans because houses typically go up in value over time, you can’t pick up a house and skip town, and if you don’t pay your mortgage loan, the bank can repossess your house, essentially kicking you out.

A secured loan is one where you are buying something the bank can take back – like a car, boat, etc. Generally the bank can take it back, but they depreciate in value over time, especially right away. So if you don’t pay the loan back, the bank takes the car back (repo man), but the car you bought for $30,000 might only be worth $20,000, so they charge you a higher rate in case they have to take the car back, to reduce the risk of loss.

An unsecured loan, like a credit card, has the highest interest rates. That’s because it is often used to buy things that you cannot return, or the bank cannot take possession of. Think of paying for a dinner, or a vacation on a credit card. The bank can’t take those items back, so to reduce their risk of loss, they charge the highest interest rate for these items.

Current Interest Rates

Now I used 5% interest for a savings rate and 10% for buying a car – however, that isn’t always the case. In fact, now a days, if you have good credit, you’ll see rates much lower than that. Why?

Well, banks loan each other money? If they can get money from another bank cheaper than you, they will. So, your money doesn’t have as much value to them. This means borrowing money is cheaper too…but if you’re trying to save, good luck.

If the over night lending rates for banks were to go up higher, that would make savings accounts pay more, but it would also cost more to buy a car, house etc. Due to a variety of complex economic reasons, we’ve had really cheap interest for nearly two decades… it’s like our economy is hooked on it, and I don’t see us breaking that fix any time soon.