An interest rate is the price of money over time. For a borrower, it is the cost of using someone else’s money; for a saver, it is the reward for letting someone else use yours. Rates are almost always quoted per year, but how they are applied — and what they include — varies. Understanding the differences helps you compare offers properly.
What the rate measures
A rate of 5% per year means that for every $100 of principal, $5 of interest is charged or earned over a year. If the time is shorter, the interest is proportionally smaller: 5% for six months is roughly 2.5%. If interest compounds, the actual growth over a year is a little more than the quoted rate.
Nominal vs effective rates
- Nominal rate — the headline annual rate before compounding. Also called the stated rate. On loans in the US it is close to the APR.
- Effective annual rate — the true yearly growth after compounding. For savings this is the APY.
Effective rate = (1 + nominal/n)n − 1
A nominal 5% compounded monthly is an effective 5.1162%. A nominal 22% on a credit card compounded monthly is an effective 24.36%. Compare savings by APY and compare loans by a consistent measure (APR including fees, or effective rate).
APR vs APY
APR (annual percentage rate) is typically used for borrowing. In many countries it must include certain fees, so it shows the yearly cost of credit — but it usually does not include compounding. APY (annual percentage yield) is used for savings and includes compounding. More in What Is Annual Percentage Yield?
Fixed vs variable rates
- Fixed rates stay the same for an agreed period — predictable payments or returns.
- Variable (or floating) rates move with a benchmark, such as a central bank rate or an interbank reference rate, plus a margin. They can rise or fall during the term.
Calculators, including ours, assume a fixed rate. For a variable rate, treat the result as a scenario and try a few rates.
What moves interest rates?
- Central bank policy — central banks set a short-term policy rate to manage inflation and employment. Banks’ savings and lending rates tend to follow it.
- Inflation expectations — lenders want to be paid more than inflation, so higher expected inflation pushes rates up.
- Risk — riskier borrowers pay higher rates to compensate lenders for the chance of not being repaid.
- Term — longer commitments usually, but not always, carry higher rates.
- Competition — banks competing for deposits may offer higher savings rates.
Real interest rates
The real rate is the return after inflation — what happens to your purchasing power:
Real rate = (1 + nominal) ÷ (1 + inflation) − 1
With a 5% savings rate and 3% inflation, the real rate is 1.05 ÷ 1.03 − 1 = 1.94%. A quick approximation is nominal minus inflation (2%). If inflation is higher than your savings rate, the real rate is negative. See How Inflation Affects Savings.
How a rate is applied
To apply an annual rate, three choices must be clear: whether interest is simple or compound, how often it compounds, and which day-count convention is used for part periods. Our calculators show each assumption next to the result so you can match your account.
Key takeaways
- Rates are quoted per year; compounding makes the effective rate higher than the nominal rate.
- Use APY for savings comparisons; use APR or effective rates for loans.
- Real return = what is left after inflation.
Find the rate behind any growth with the Interest Rate Calculator.