Interest can affect so many parts of our financial lives – earning money, spending money, calculating what things really cost. But what is it? And why is it changing so much in 2022?
Since 2008 (the Great Recession), interest rates have been really low. This means you hardly earn any interest on your savings account but also allowed people to borrow money at lower rates. This was most dramatic during in 2021, when Americans were able to secure mortgages at record low interest rates.
But what even is interest? It’s the percentage amount charged to someone who borrows money. Some debt – like credit cards – charge high interest rates. Other rates, like mortgages, are lower All of them can change from year to year, especially on a new account.
What about the interest you earn, like on savings accounts?
When you put your money into a savings account, the bank gets to use your money for other things. Most commonly, they lend it to other people.
That’s where they get money to lend people money for mortgages to buy houses or other loans. They take it from deposits other people make.
Yes, they really lend your money to other people. That’s why they have money to pay you interest on your savings account.
Interest rates on savings accounts vary by year and bank. But let’s say I open a savings account that pays 2% interest annually and deposit $1,000 today. The original amount is called the principal balance, $1000. The interest rate is also called the rate of return.
If they paid interest once a year, I’d make 2% of $1000 or $20 a year.
But they actually pay interest every month, so it compounds. In other words, if you leave the interest in the account, you are getting paid interest on the interest you made last month.
Account makes 2% on $1000 = $1000*(2%/12) monthly for a year = $20.18
You’d have $1020.18.
It doesn’t sound like much but at the end of five years, you’d have earned $105.08 on the original $1000.
Interest rates on savings accounts change over time. They’ve been going up in 2022. When I made a video on this topic in 2020, I used 1% as the rate on account – and that was a high rate to find at the time.
Different interest rates on your savings really change the end result.
I know I’ve thrown a lot of numbers at you here, but let’s finish by talking about how interest works on a credit card. Credit cards are one of the most common loans Americans take, along with mortgages and student debt.
Credit card interest rates vary wildly by card, but let’s say I have a card that charges 15% interest on unpaid charges.
If I spent $1000 last month and only pay $500 on the bill, I will owe interest to the credit card company on the other $500. If it takes me a year to pay it, I will $580.90.
Why? Credit card companies compound interest daily – in addition to the super high amounts they charge.
In other words (show words) When you owe interest on debt and don’t pay it off, you owe more interest on the original interest.
That’s compound interest – and it can make a big difference, whether good or bad. So paying for things I can’t afford on a credit card adds up super fast! But it’s also what makes interest compound on your savings accounts and retirement accounts.
This is a lot of information, but all related to how interest works in different areas of banking and your finances. If you have any questions, please put in the comments or message me here <link to contact page>.
To calculate how much interest you would earn with your savings and different interest rates, check out this Compound Interest Calculator.