How Interest Rates Work
Simple vs compound interest, fixed vs variable rates, how the Fed funds rate affects your loans, and how to compare rates across different products.
What is an interest rate?
An interest rate is the price of using money that isn't yours — expressed as a percentage of the principal per year. When you borrow, you pay interest. When you save or invest, you earn it.
Interest rates exist because money today is worth more than money in the future (the "time value of money") and because lenders take on risk. A higher rate compensates for a longer time horizon, a riskier borrower, or higher expected inflation.
Simple interest
Simple interest is calculated only on the original principal — interest doesn't earn interest. Rare in practice but useful to understand the base concept:
Simple Interest = Principal × Rate × Time Example: $10,000 at 5% for 3 years Interest = $10,000 × 0.05 × 3 = $1,500 Total owed = $11,500 Each year: $500 exactly — never more.
Compound interest
Compound interest is calculated on the principal plus previously accumulated interest. Interest earns interest. This is how savings accounts, CDs, bonds, investment returns, and most loans actually work:
A = P × (1 + r/n)^(n×t)
A = final amount
P = principal
r = annual rate (decimal)
n = compounds per year
t = years
Same example: $10,000 at 5% for 3 years
Annual compounding (n=1):
A = 10,000 × (1.05)^3 = $11,576 (+$76 vs simple)
Monthly compounding (n=12):
A = 10,000 × (1 + 0.05/12)^36 = $11,615 (+$115 vs simple)
Daily compounding (n=365):
A = 10,000 × (1 + 0.05/365)^1095 = $11,618Compounding frequency matters, but the marginal gain from daily vs monthly compounding is small. What matters enormously is time — compounding's power is exponential over decades, not years.
Fixed vs variable rates
Fixed rate
The rate stays the same for the entire loan term. Your payment never changes. Predictable, but you pay for certainty — fixed rates are typically slightly higher than variable at origination. Best when rates are low and you're locking in for a long time.
Variable (adjustable) rate
The rate is tied to a benchmark (typically the Fed funds rate or SOFR for US loans) plus a fixed margin. It resets periodically — monthly, annually, or on a defined schedule. Lower initially, but your payment can increase significantly if rates rise. Common in: ARMs (adjustable-rate mortgages), HELOCs, credit cards, student loans.
How the Fed rate affects you
The Federal funds rate is the interest rate at which US banks lend money to each other overnight. The Federal Reserve sets it as its primary tool for controlling inflation and economic growth.
This rate ripples through the entire economy:
→ Prime Rate = Fed funds rate + 3%. Most variable consumer rates are priced off Prime.
→ HELOC, credit card APR move up/down with each Fed rate change
→ Mortgage rates correlate with 10-year Treasury yields (not directly Fed rate)
→ Savings account APY rises when Fed rate rises — high-yield savings accounts follow quickly
When the Fed raises rates to fight inflation, borrowing becomes more expensive and saving becomes more rewarding. When it cuts rates to stimulate growth, the reverse happens.
Nominal vs real interest rates
The nominal rate is the stated rate on the loan or account. The real rate adjusts for inflation:
Real rate ≈ Nominal rate − Inflation rate Example: Savings account: 4.5% APY Inflation: 3.2% Real return ≈ 4.5% − 3.2% = 1.3% Your money grew by 4.5%, but your purchasing power only grew by about 1.3%.
This is why keeping money in a low-interest account during high inflation periods causes you to lose purchasing power — even though your balance number grows.
Frequently asked questions
- Why do credit cards have such high interest rates?
- Credit cards are unsecured revolving credit — there's no collateral, borrowers can draw and repay freely, and default rates are higher than mortgages or auto loans. Lenders price in this risk with higher rates. Additionally, cardholders who pay in full each month pay no interest, so the high rates are effectively subsidized by cardholders who carry balances.
- What does "interest rate" vs "APR" mean on a mortgage?
- The interest rate is the base cost of borrowing — what determines your monthly payment. APR includes the interest rate plus fees (origination fees, points, broker fees) spread over the loan term. APR is always higher than the interest rate and is more useful for comparing total loan cost between lenders.
- Does paying extra principal reduce the interest I owe?
- Yes — on most loans (mortgages, auto loans, personal loans), interest is calculated on the remaining principal balance. Every extra dollar of principal you pay reduces the balance interest is charged on, which reduces total interest over the life of the loan. Even small extra payments early in a mortgage can save thousands in interest.