When credit card companies and lenders let you borrow money, they don’t give it to you for free. How much you pay to borrow money is determined by the interest rate. So what is an interest rate? And how does it work?
Here’s what we’re going to cover:
- What is an interest rate?
- How do interest rates work?
- How are interest rates determined?
- The impact of high vs low interest rates
- How to get lower interest rates as a borrower
- APR vs interest rates
Key takeaways
- The interest rate is a percentage that tells you how much money you have to pay for borrowing money. This is in addition to paying back the money you borrowed.
- Your interest rate is based on many factors. One important factor is your credit score. In general, a higher credit score will mean a lower interest rate.
- Interest rates and annual percentage rates (APRs) both express the cost of borrowing money from a lender. However, these two terms are not the same. Interest rate tells you how much interest you will pay on the loan. APR factors in the interest and the loan’s fees.
What is an interest rate?
When you use a credit card or take out a personal loan, you’re borrowing money from your lender. To provide loans or lines of credit to more people, financial institutions need to make a profit. They make this money by charging interest and other fees.
Your interest rate is the cost you will pay each year to borrow money expressed as a percentage rate. The amount of money that you borrow is called the principal. By multiplying the principal by the interest rate, you’ll find out how much interest you owe each year on your loan payment.
You can also benefit from interest if you have money in a savings account at a bank. When you store your money at a bank, you’re technically lending it to them. It’s still your money, but the bank is allowed to lend it to other people temporarily.
Since the bank is benefitting from using your money, they pay you interest in return. You can think of this interest as the reward you get for storing your money in the bank.
How do interest rates work?
The way interest rates work depends on a few factors. The first factor is whether the interest rate is fixed or variable. The second factor is whether the interest is simple or compound.
Let’s take a look at what these differences mean.
Fixed interest rates vs variable interest rates
Interest rates can be fixed or variable.
Fixed interest rates stay the same during the entire duration of your loan. Let’s say you take out a fixed-interest 30-year mortgage. Your interest rate will stay the same for all 30 years. Fixed interest rates allow you to enjoy predictable payments.
Variable interest rates change over time based on benchmark interest rates and, in the case of loans and credit cards, your credit score. For example, your interest rate could be 14 percent during one period and 16 percent during another period. One benefit of variable interest rates is that they allow you to save money when interest rates go down.
Simple interest vs compound interest
There’s also a difference in how your interest payments will be calculated. The calculation differs depending on whether your interest is simple or compound.
Simple interest is the interest that you pay specifically on the principal. It’s interest paid on the principal and nothing else.
Compound interest includes interest paid on the original principal, as well as any remaining interest from the previous period. You can think of compound interest as interest on interest.
Let’s say that you keep $100 in the bank at a 5 percent interest rate. In the first year, you earn $5 of interest. Your balance is now $105. This is true whether your bank uses simple interest or compound interest.
The second year, this is what happens:
With simple interest you earn another 5 percent on the original principal of $100. This means you’ll get another $5. Your new balance will be $110.
With compound interest you earn interest on both the principal and the interest from the last year. Which means your 5 percent interest rate is applied to the new balance of $105. This means that you’ll receive $5.25 in interest during the second year. Your new balance will be $110.25.
Compound interest causes the interest amount to increase each period. If you’re earning interest by storing your money in the bank, compound interest benefits you. If you’re being charged interest with a loan or credit card, compound interest can cost you more money.
How does interest work with loans?
When you pay back a loan, you pay the principal, interest, and any fees that your lender charges. Each loan will have a different requirement for the order in which they’re paid off.
For example, some loans have you pay off all the interest first. After that, your payments start going toward the principal. Other loans combine both expenses, so you pay off a portion of the principal and a portion of the interest with each payment.
How does interest work with credit cards?
With credit cards, you pay interest on your credit card balance, the amount you borrow from the bank each month that you don’t pay off. You won’t owe any interest if you pay off your total balance each month.
If you have a balance on your credit card, you’ll be charged interest that is compounded. As a result, the interest you were charged last payment period will be charged interest the next payment period. By paying off your credit card balance each month, you can avoid costly interest charges.
How are interest rates determined?
Interest rates are influenced by a few factors:
The Federal Reserve is the central banking system of the United States. It sets the federal funds rate , which is used to determine short-term interest rates on loans financial institutions make to each other.
U.S. Treasury notes and bonds are two types of investments. Depending on investors’ demand for them, fixed-interest rates will either go up or down.
The banking industry, like many other industries, bases their prices around their competition and the current economy. Lenders watch the behaviors of the Federal Reserve and U.S. Department of the Treasury adjust their interest rates as the market changes accordingly to stay in business and serve their customers.
Your credit score is used to help figure out how likely you are to make your payments on time. If you have a high credit score, you’ll usually qualify for lower interest rates.
Impact of high vs low interest rates
Interest rates fluctuate over time. When interest rates are higher, it will cost you more in interest to borrow money. As a result, people are less likely to take out loans and credit cards. If your savings account at your bank has a high interest rate, your money will earn more interest.
A lower interest rate has the opposite effect. Since loans with a lower interest rate are cheaper, people are more likely to borrow money. They might take out loans to buy homes, start new businesses, or pay for unexpected expenses. When the savings account at your bank has a low interest rate, your money will earn less interest.
How to get lower interest rates as a borrower
If you’re taking out money with a loan or credit card, you want to get the lowest interest rate you can qualify for. To improve your interest rate options, it helps to have a higher credit score. There are many ways to improve your credit score over time. Some of these include:
- Making your credit payments on time
- Keeping your credit balances low
- Having a mix of credit types
APR vs interest rates
Annual percentage rate (APR) is a term that’s often confused with interest rates. Unlike interest rates, APR measures the total cost of a loan, including its interest and fees. These fees could be things like legal fees, application fees, origination fees, and more.
APR tells you the total cost of taking out money each year. Interest rates help you calculate the cost of your yearly interest payments. Both metrics are very important. However, APR is better for comparing loans from different lenders because it factors in their loan fees.
Oportun: Affordable interest rates, no credit history required
Interest rates are very important to understand. They determine how much it costs to take out a loan and how much money you’ll earn by leaving funds in a savings account at a bank.
If you want to build a better financial future, check out the loans offered through Oportun. Here at Oportun, our mission is to provide affordable financial services so you can even if you don’t have any credit history. You can apply for a loan or credit card with an affordable interest rate through Oportun even if you don’t have any credit history yet.
Sources
Federal Reserve Board. Open market operations.
Experian. What is a good credit score?
Investopedia. Variable interest rate.
The information in this site, including any third-party content and opinions, is for educational purposes only and should not be relied upon as legal, tax, or financial advice or to indicate the availability or suitability of any Oportun product or service to your unique circumstances. Contact your independent financial advisor for advice on your personal situation.
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