Understanding the 7 Types of Interest Rates

Interest is the money that someone pays for borrowing funds. If you take out a loan, for instance, you will pay interest in exchange for using that capital. On the flip side, if you deposit money with your bank, you may earn interest for letting the bank hold your funds. There are many different forms interest can take, which can influence how it accrues and in turn, affecting how much you may pay, or earn, in interest over time. Here are seven different types of interest that you should know.

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1. Simple Interest

This rate, otherwise known as “nominal” or “regular” interest, is your basic interest rate. It represents the straightforward calculation of how much you owe without correcting for any other factors, such as time, inflation or payment schedule.

For example, let’s you borrow $1,000 at a 5% annual interest rate. In this case, you would pay $50 per year in simple interest.

The simple interest rate is generally the rate you see advertised. For example, a bank might offer loans at 4%. That would be simple interest. However, simple interest is also rare. While a useful shorthand, it’s extremely uncommon for a lender to collect one flat fee on a periodic basis. Instead, almost all loans have compounding periods or variable rates, which make the interest payments more complicated than they may seem at face value.

All of which to say, simple interest is good for getting a sense of your loan’s rate, but it’s almost never the end of the story.

2. Compound Interest

With compound interest, interest is calculated on a periodic basis and then added to the principal amount. It’s often referred to as “interest on interest.” It is different from simple interest in that the rate at which your interest is calculated and the rate at which your interest accrues are different.

For example, say that you take out a $1,000 loan with an annual interest rate of 5%. You can take two versions of this loan:

5% annual, simple interest
5% annual, compounded biannually

The first version of this loan means that the term at which your interest is calculated is the same as the term at which it is added to your debt. This means that once per year, the lender will charge you 5% for this loan.

The second version of this loan means that your interest is calculated annually but added to your debt twice per year. As a result, every six months, your lender will take the amount of interest that has accrued up until that point (2.5% in our example) and add it to the amount you owe. Six months later, they will do the same again. But that second time, the amount of interest added will be higher because the principal will have increased by the amount of your last interest calculation.

Most loans have some form of compound interest. The rate at which your interest compounds on a loan is extremely important.

3. Effective Interest

Effective interest measures how much you pay on a loan after adjusting for compounding over time. This rate is almost always higher than simple interest, and it reflects the true amount owed on a loan.

Take our example from above again. Say that you have a $1,000 loan with an annual interest rate of 5%. The lender offers two versions of this loan:

5% annual, meaning that they calculate your interest and add it to the value of your loan at the end of each year
5% compounded biannually, meaning that every six months they calculate the accrued interest and add it to the value of your loan

In the first case, you will owe $50. Since the loan is compounded at the same rate that the interest is calculated (annually), the effective rate is the same as the simple rate.

In the second case, the loan is compounded twice per year, meaning the lender’s calculations would look like this:

First period – $1,000 * 2.5% (half of the annual interest, since it compounds twice per year) = $1,025
Second period – $1,025 * 2.5% (the other half of the annual interest) = $1,025.62

The effective interest on this loan is 5.062%. If the loan compounds quarterly, the lender would perform this calculation four times per year at a rate of 1.25% per quarter. If the loan compounds monthly, they would do so 12 times per year, and so on. A more frequent compounding rate always means a higher effective interest rate.

4. Fixed Interest

This refers to an interest rate that stays the same throughout the lifetime of a loan, or at least so long as you abide by its conditions.

For example, say you have a 5% fixed interest rate. This means that you will pay 5% of the loan’s outstanding principal each time payments are due. The lender cannot change that rate based on market conditions or any other unilateral basis.

However, it’s important to note that lenders often include terms that let them change the interest rate if you run late or miss a payment. This is particularly common with credit cards, which frequently offer very low fixed rates with an option to adjust upward if you run so much as a day late paying your bill.

Fixed interest rates are usually a better deal for the consumer. While it’s possible to end up with a higher interest rate, in the long run, you’re usually better off taking a loan based on known and certain terms, rather than adjustable ones.

5. Variable Interest

In contrast to fixed interest, a variable interest rate can change over the lifetime of a loan.

For example, say that you have a 5% variable interest rate. This means that you start out paying 5% of the loan’s outstanding principal each time payments are due. However, the lender can periodically change that rate over the lifetime of the loan. Next year, your interest rate might be 6%, while the year after, it may drop to 4%.

It is rare, if ever, that a lender can change variable interest rates based on their own discretion. Instead, the terms of your loan will establish the specific benchmarks for how your lender will calculate variable interest. Usually, a variable interest rate varies according to some external benchmark. In most cases, banks use the prime rate (an industry benchmark) or the federal funds rate.

So, for example, your bank might offer you a variable interest rate set at 2% plus the prime rate. This means that if the prime rate is 4%, the interest rate on your loan will be 6%. If the prime rate drops, so will your interest rate. If the prime rate increases, the same will happen to your loan’s rate.

Variable interest rates are a common way for banks to attempt to insulate themselves from market fluctuations. It allows them to adjust for factors like inflation and rising interest rates, so they aren’t saddled with under-market loans. For this same reason, variable interest rates are usually a bad deal for consumers.

6. Real Interest

Real interest calculates the rate of interest after accounting for inflation. Its purpose is to correct for the fact that most loans are long-term instruments.

While inflation is typically a minor concern over a period of months, over a period of years, it can dramatically change the value of a loan. As a result, a real interest rate indicates how much money the lender has made after adjusting for the reduced value of those payments year-over-year.

For example, say that a loan has a 5% interest rate during a year in which inflation hit the Federal Reserve’s benchmark 2%. This would mean that the loan had a real interest rate of 3%, reflecting the fact that the lender received 3% in additional value after adjusting for the reduced spending power of that money.

7. Accrued Interest

Accrued interest refers to the amount of interest that has built up on an account over the course of a payment period. It reflects the difference between the rate at which interest accumulates and the rate at which payments are due.

For example, say that you have a $1,000 loan with a 5% simple, annual interest rate. This means the borrower owes $50 in interest per year, due at the end of each year. At the six-month mark, the borrower will owe $25 in accrued interest. This is the amount of money that will have accrued over the period of the loan, but which is not yet due.

Accrued interest is particularly important for loans that have different compounding and payment schedules. For example, say that your payments are due at the end of each month but your loan compounds daily. (This is a pernicious habit among some credit cards.) Your accrued interest will reflect the amount by which your loan grows each day, which is in turn compounded to your principal, until payment is due at the end of the month.

How to Compare Interest Rates

The advertised rate does not always reflect the full cost of borrowing. Before comparing loans, check whether the rate is fixed or variable, how often interest compounds and whether fees increase the amount you will pay.

For loans, the annual percentage rate (APR) can provide a more useful comparison. This figure incorporates both the interest rate and certain borrowing costs. Two loans with the same stated rate can have different APRs when their fees differ.

Savings products use a different measure. Annual percentage yield (APY) reflects compounding, making it useful for comparing savings accounts, certificates of deposit (CDs) and other interest-bearing deposits.

Compounding frequency also matters. When borrowing, more frequent compounding can increase the balance on which future interest is calculated. When saving, the same effect can increase earnings, since accumulated interest can generate additional returns.

Fixed and variable rates require another comparison. A fixed rate provides more predictable borrowing costs. Meanwhile, a variable rate can rise or fall with its benchmark, so a lower starting rate does not guarantee a lower cost over the full term.

Bottom Line

Interest payments reflect the amount that someone pays to borrow money. From simple interest to accrued interest, there are many different ways to calculate interest. It’s important to understand the main seven types of interest rates, as the differences between them influence how interest is calculated and, as a result, how much you may ultimately pay in interest.

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