Banking 101

You are likely clear on the concept of interest – you owe more than what you borrowed when paying back over a period of time. However, the topic of interest rates might be a little murkier. There are a lot of terms surrounding interest rates that include acronyms and financial jargon, which can be confusing.

In truth, interest rates are a critical component to many of the financial decisions that we make. Borrowing, saving and spending can all be influenced by the current rates. For this latest Banking 101 piece, we will tackle the most common terminology surrounding interest rates and simplify some of the terms you might see or hear on commercials, billboards or other advertisements.

Simple Interest vs. Compound Interest

These are two of the most common interest types, and there is a key difference between the two. Simple interest is an annual percentage of the amount owed, whereas compound interest accrues or builds over time. You often hear the term “compound interest” when referencing the interest someone can earn from a savings account.

So, let’s use a savings account as an example. If a savings account has $1,000 in it at an annual 5.0% simple interest rate, you will earn $50 in interest each year as long as your original $1,000 stays in your account. Over 10 years, that $1,000 investment will have earned you an extra $500.

However, compound interest builds upon itself over time. The interest you earn from the previous year will build upon next year’s total savings. While year one will be the same as the “simple interest” scenario, in year two, you will be earning interest on $1,050 instead of $1,000. After 10 years with a 5.0% compound interest rate, you will have totaled $1,628.89, more than $100 above the simple interest rate scenario.

APR vs. APY

Both of these acronyms, APR (Annual Percentage Rate) and APY (Annual Percentage Yield), are very common amongst banks, credit unions, mortgage companies and other financial institutions when advertising their rates. APR refers to the yearly interest rate that the borrower assumes on a loan or the rate you earn before compounding interest if you lend it.

You’ll often see APR used alongside credit cards, mortgages, car loans or personal loans.

Meanwhile, APY refers to the rate which your money grows in a year when factoring in compound interest. APY is most often used when highlighting savings accounts such as money market accounts or certificates of deposit (CDs).

Fixed Rate vs. Variable Rate

This terminology is fairly easy to explain in the context of a home loan.

A fixed interest rate loan is a loan where the rate remains constant during the entire term of the loan. So, if you get a 30-year fixed rate home mortgage, the interest rate will be the same in year 1 as it is in year 30, with no change in between.

A variable rate loan, on the other hand, fluctuates throughout the term of the loan based on how market rates change, and often correlates directly to US Treasury rates (more on that below). Having a variable interest rate on your home loan could result in a lower introductory rate but will increase in a growing rate environment or could decrease in a declining environment.

In certain situations, a loan may start off with a fixed rate but then convert to variable at some point in the future.

Prime Rate vs. Federal Funds Rate

Now that we have the basics of some common interest rate terminology down, let’s get a little more complex with the prime rate vs. the federal rate. Both rates are benchmark rates that financial institutions use to set their own interest rates.

The federal funds rate is set by the Federal Reserve Open Market Committee (FOMC) at their periodic meetings.   It’s based on a multitude of factors including inflation, employment indicators and the general state of the economy. The FOMC meets eight times a year to establish that rate with a primary goal of keeping the U.S. economy steady. Currently, this rate sits in a range of 3.75% to 4.00%. The Fed Funds rate is generally the rate banks borrow funds on an overnight basis, and it is often tied to the APYs offered on various money market, savings accounts and CDs.

You may have seen recently that the Fed Fundsrate was lowered by 0.25% in each of their September and October FOMC meetings.  These changes affect the next rate we will dive into – the prime rate.

The prime rate is often a starting point for Banks when setting the rate for its most creditworthy customers and is typically set at 3% above the Federal Funds rate.  There are numerous other indexes banks use in setting rates for small business loans, mortgages, credit card, auto and personal loans.  Some of these you may have heard of, including Federal Home Loan Bank (FHLB) and US Treasury Note rates and the Secured Overnight Financing Rate (SOFR).

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