# How does interest work?

> Interest is the yearly price of money. You earn it on savings, you pay it on debt, and it compounds both ways.

Source: https://www.walletprep.com/learn/how-interest-works/ · Updated 2026-10-01 · Money basics

Interest is the price of using money for a year, written as a percent. Savings pays it to you, debt charges it to you, and compounding makes both grow faster over time.

## Key facts
- **Interest is the price of money.** When you lend money to a bank by keeping it in savings, the bank pays you. When you borrow, you pay the lender. Either way, interest is a percent of the balance, quoted per year.
- **APR is the yearly rate.** Annual percentage rate, or APR, is the yearly rate on a loan or credit card. Lenders charge a slice of it each month or each day.
- **APY is what a year really adds up to.** Annual percentage yield, or APY, counts compounding. It is the true yearly growth of a savings account, and it is always equal to or a bit higher than the rate before compounding.
- **Compounding is interest on interest.** Once interest is added to your balance, the next round of interest is figured on the bigger total. Over years, that makes savings and unpaid debt both grow faster.

## Why interest exists
Money you can use today is worth more to you than the same money next year. So anyone who hands over money for a while asks to be paid for waiting. That payment is interest.
When your money sits in a savings account, the bank lends it to other people and pays you a share as interest. When you borrow, through a credit card, a car loan or a student loan, you are the one paying for the use of the money. Debt simply means money you borrowed and still owe.

## How a rate turns into dollars
Interest rates are quoted per year. A 5% yearly rate on $1,000 is $1,000 × 5% = $50 for a full year. Half the balance means half the interest, and twice the rate means twice the interest.
Most accounts don't wait a full year. They figure interest every day or every month at a slice of the yearly rate. To find the monthly rate, divide by 12. A card at 24% charges 24% ÷ 12 = 2% a month, so $1,000 left unpaid adds $20 in one month.

## Simple and compound interest
Simple interest is figured only on the original amount. $100 at 10% simple interest earns $10 in year 1 and $10 in year 2, for $20 in total.
Compound interest is figured on the balance, including interest already added. $100 at 10% compounded once a year earns $10 in year 1, making $110. Year 2 earns 10% of $110, which is $11. The total is $21, $1 more than simple interest.
One dollar sounds small. Over 10, 20 or 30 years, the interest on interest grows to be a large part of the balance. Most savings accounts and almost all credit cards use compound interest.

## APR and APY
APR is the yearly rate before compounding. For loans, it can also include some fees, so it shows the yearly cost of borrowing. Credit cards, car loans and mortgages all quote an APR.
APY is the yearly rate after compounding. Savings accounts quote it so you can compare them fairly. A 4% rate compounded monthly gives an APY of about 4.07%. Compounded daily, it is about 4.08%.
The same math works against you on debt. A card with a 24% APR charges 2% each month. If you never pay, the balance grows by about 26.82% in a year, more than the 24% on the label.

## Why the same idea grows savings and debt
Compounding doesn't care which side you are on. It adds interest to the balance, then charges or pays interest on the bigger balance. On savings, that works for you. On unpaid debt, it works against you.
Debt rates are usually much higher than savings rates. That is why paying down a 24% credit card before building extra savings beyond your emergency cushion often makes sense: every dollar of that debt costs far more than a dollar in savings earns.

## A worked example: the same $1,000 on both sides
Priya has $1,000 in savings at 4% a year and owes $1,000 on a card at 24% APR. Both compound monthly. She adds nothing and pays nothing for a year.

- Savings at 4% a year: $1,000
- Interest earned, 12 months: $41
- Savings after a year: = $1,041
- Card balance at 24% APR: $1,000
- Interest charged, 12 months: $268
- Owed after a year: = $1,268
- Simple interest at 24%: $240

1. Savings: 4% ÷ 12 is about 0.33% a month, added each month. After 12 months, $1,000 grows to $1,041.
2. Card: 24% ÷ 12 = 2% a month on a growing balance. After 12 months, $1,000 grows to $1,268.
3. Simple interest would be $1,000 × 24% = $240. Compounding adds $28 more, so the real yearly cost is about 26.82%.

### What different APRs cost on a $1,000 balance in one month

| APR | Monthly rate | Interest on $1,000 in one month |
| --- | --- | --- |
| 6% | 0.50% | $5.00 |
| 12% | 1% | $10.00 |
| 18% | 1.50% | $15.00 |
| 24% | 2% | $20.00 |
| 30% | 2.50% | $25.00 |

## Common mistakes
- **Comparing APR to APY.** A savings APY and a loan APR measure different things. Compare savings accounts by APY with each other, and loans by APR with each other.
- **Ignoring the monthly rate.** A 24% rate sounds like a once-a-year cost, but it is charged every month. Leaving a balance even a few months adds up fast.
- **Thinking small balances don't matter.** Interest is a percent, so it is charged on every dollar. A small card balance left for years can cost more than the original purchase.

## Questions people ask
### What does 0% APR mean?
No interest is charged on that balance for a set time. When the offer ends, the regular APR applies to whatever is still owed, so plan to pay it off before then.

### How often is interest added to a savings account?
Many banks figure interest daily and add it to your balance once a month. The APY already includes this, so you don't need to do the math yourself.

### Do I pay tax on savings interest?
In the US, savings interest is usually taxable income. Your bank sends a Form 1099-INT if you earn $10 or more in a year. See the IRS for your own situation.

### Why is my credit card interest so much higher than my savings rate?
Card debt has no collateral and some people don't pay it back, so lenders charge more to cover that risk and earn a profit. That gap is why card debt grows faster than savings.

## Do this today
Find the APY on your savings account and the APR on each card or loan you have. Write them side by side. The highest APR is the debt costing you the most each month.

## Sources
- [CFPB: How does my credit card company calculate the interest I owe?](https://www.consumerfinance.gov/ask-cfpb/how-does-my-credit-card-company-calculate-the-amount-of-interest-i-owe-en-51/)
- [Investor.gov: Compound interest calculator](https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator)
- [IRS: Topic 403, Interest received](https://www.irs.gov/taxtopics/tc403)

_General education, not personalized financial, tax or legal advice. Figures are examples. Check current rates and limits before you act._