Explain It to Me Like I'm Five: Here's How Interest Rates Work

This key feature determines how much money you earn on your savings.

When comparing savings accounts, one of the most important features to look at is the interest rate. This is expressed as a percentage, and savings accounts with higher rates pay you more money.

Interest rates can be a confusing concept. People often have questions about them, like where does this money come from? And why do some banks pay so much more than others? Since this is such an important financial concept, here's an easy-to-understand breakdown of how interest rates work.

ELI5: How interest rates work

In the banking world, "interest" is the term for payments made from a bank to an account holder. The interest rate is how much interest the bank pays per year. Let's say a savings account has a 3.5% interest rate. That means the bank will pay you 3.5% per year to deposit money into the savings account.

Bank accounts have variable interest rates; their interest rates can go up or down at any time.​​ This mainly depends on the economy. Depending on economic conditions, the Federal Reserve may raise or lower the federal funds rate. Banks use this rate to determine their own interest rates.

So, a bank account could offer a 1% interest rate at the start of the year, and 4% a year later. After another year, it could be down to 2%. It all depends on the economy and what the Federal Reserve does.

How banks are able to pay interest

A common question about interest rates is how banks can afford to pay them without losing money. They're able to pay this with another type of interest -- the interest they earn from money they lend to consumers.

In lending, interest is a payment made from a borrower to the lender. If you get a loan with a 10% interest rate, then you're paying 10% per year for that loan.

Banks offer a wide range of these lending products and earn interest on them. These products can include:

• Credit cards
• Personal loans
• Auto loans
• Mortgages

But why would banks use their profits from credit cards and loans to pay other people interest? Because the amount they can lend partially depends on the money they have in their reserves. And their reserves are made up of people's bank account deposits.

So, by offering accounts that earn interest, a bank attracts more customers. These customers open bank accounts and deposit money. That money helps the bank lend more and increase its earnings.

However, certain banks pay much higher interest rates than others. Many online banks offer high-yield savings accounts that currently pay 3.5% or more. On the other hand, many brick-and-mortar banks pay 0.5% or less. There are two reasons for this:

1. Online banks can pay higher interest rates because they don't have physical locations. This saves them lots of money compared to brick-and-mortar banks.
2. Big banks already have established customer bases. They don't need to offer generous interest rates to convince people to use their services.

Interest rate vs. APY

There's another common term used to describe the amount of interest a bank account pays: annual percentage yield (APY). It's actually a more accurate measure of how much interest you'll earn with a bank account.

That's because banks offer what's known as compound interest. You earn interest on your money, and that interest gets added to your balance. This can happen daily or monthly, depending on the bank account. Then, you earn more interest on that balance. Remember, that balance now includes your original deposit and the previous interest you earned. You're effectively earning interest on top of interest.

APY tells you how much an account earns with that compounding. As such, an account's APY tends to be a bit higher than the interest rate.

Let's say you have a savings account with a 4.9% interest rate. It compounds monthly, meaning interest is calculated and added to your balance each month. With that compounding, the account's APY will be around 5%.

There's a lot that goes on behind the scenes with bank accounts and the interest they earn. The APY is the easiest way to see how much interest you'll really earn with an account. In most cases, it's good to pick an account with a high APY to earn more interest on your money.