How do interest rates work?

What is an interest rate?

The US Consumer Financial Protection Bureau (CFPB) puts it simply: “The interest rate is the cost you will pay each year to borrow the money, expressed as a percentage rate.” Interest is the price of using someone else’s money for a period of time.

• When you borrow (a mortgage, a car loan, a credit card), you pay interest to the lender.
• When you save (a bank savings account, a certificate of deposit), the bank pays interest to you, because it is effectively borrowing your money.

Rates on loans and savings are quoted per year, which is why you see the word “annual” in APR and APY — two terms explained below. Behind all of these sits a benchmark that the central bank steers.

What is the federal funds rate?

The Federal Reserve explains: “The federal funds rate is the interest rate charged by banks to borrow from each other overnight.” You will never pay this rate yourself, but it sits at the base of the US interest-rate system.

“The Federal Open Market Committee (FOMC) sets a target range for the federal funds rate.” According to the Fed, changes in that range influence short-term interest rates for other financial instruments, which in turn affect the spending decisions of households and businesses. In other words, a change in the Fed’s target ripples out to other short-term borrowing and saving rates — although your own lender or bank sets the exact rate you get.

Where is the Fed rate now?

At its meeting ending 16 September 2026, the FOMC said: “The Committee decided to raise the target range for the federal funds rate by 1/4 percentage point to 3-3/4 to 4 percent”. Its statement also noted: “Inflation remains elevated.”

The Fed’s published history shows how the range has moved recently:

A quarter of a percentage point is also called 25 basis points. The Fed links rate decisions to its goals of maximum employment and 2% inflation — see what inflation is. The range has changed four times since September 2025, so check the Fed’s site for the current figure.

What is the difference between nominal and real interest rates?

The European Central Bank (ECB) explains: “The nominal rate of interest is the rate that is actually agreed and paid.” It is the number on your loan agreement or savings account.

The real rate adjusts for inflation. The ECB says “Taking inflation into account shows the real cost of borrowing and the real return on savings”, and gives the simple formula: Real interest rate = nominal interest rate − inflation.

The ECB’s own example: €1,000 saved for a year at 2.5% becomes €1,025. If inflation is 3%, the real rate is 2.5% − 3% = −0.5% — you have more euros, but they buy less.

Illustrative US version: a savings account paying 3.0% while CPI inflation is 3.4% (the BLS figure for August 2026) gives a real rate of about 3.0 − 3.4 = −0.4%. $1,000 becomes $1,030, which buys what $1,030 ÷ 1.034 = $996.13 bought a year earlier.

What is the difference between APR and APY?

These two acronyms appear on almost every loan and savings product in the US, and they answer different questions.

APR. The US Consumer Financial Protection Bureau (CFPB) says an APR “is a broader measure of the cost of borrowing money than the interest rate.” For a mortgage, “The APR reflects the interest rate, any points, mortgage broker fees, and other charges that you pay to get the loan. For that reason, your APR is usually higher than your interest rate.” For credit cards, the CFPB notes the yearly rate is called the APR, and that on most cards you can avoid interest on purchases if you pay your balance in full each month by the due date.

APY. The CFPB’s Truth in Savings rule (Regulation DD) defines APY as “a percentage rate reflecting the total amount of interest paid on an account, based on the interest rate and the frequency of compounding for a 365-day period”. The plain “interest rate”, by contrast, “does not reflect compounding”. Because APY includes compounding, it is the fairer way to compare savings accounts.

How do you calculate APY from an interest rate?

Regulation DD’s formula is: APY = 100 × [(1 + Interest ÷ Principal)^{(365 ÷ Days in term)} − 1]. The rule’s own example: $61.68 of interest on $1,000 over 365 days gives an APY of 6.17%.

Illustrative example: an account pays a 5.00% interest rate, compounded monthly.

1. One year’s interest on $1,000 = 1,000 × ((1 + 0.05 ÷ 12)¹² − 1) = $51.16.
2. APY = 100 × (1 + 51.16 ÷ 1,000 − 1) = 5.12%.
3. With daily compounding the same 5.00% rate gives (1 + 0.05 ÷ 365)³⁶⁵ − 1 = 5.13%.

The more often interest compounds, the higher the APY for the same rate. Our compound interest guide explains why.

What are the risks to watch with interest rates?

• Variable rates can rise. A variable-rate loan or card can become more expensive when rates go up.
• Negative real returns. Savings paying less than inflation lose purchasing power, as the ECB example shows.
• Older bonds lose appeal when rates rise. Investor.gov explains that newly issued bonds then pay more, so to sell an older, lower-rate bond before maturity “you might have to sell it at a discount.”
• Crypto “interest” is not a bank deposit. The SEC has warned that companies offering interest-bearing crypto accounts do not give the same protections as banks or credit unions, and that “crypto assets sent to those companies are not currently insured.” The Federal Deposit Insurance Corporation (FDIC) lists “crypto assets” among products its deposit insurance does not cover. A high advertised yield is not the same as an insured APY — see crypto risks and the red flags of crypto scams.

Blockhorizon is an education site. Nothing here is a recommendation to borrow, save or invest in any particular product.