What are interest rates?

The gist: An interest rate is what you must pay as a fee to a lender and is calculated as a percent of the total amount borrowed. An interest rate can also be the amount you earn from depositing money in a savings account. 

Understanding interest rates is one of the first lessons in learning more about finance. Why? Because interest rates apply to many of the biggest purchases you’ll make in life.

For example, the interest rate on a mortgage could determine if you pay $100,000 in interest to the bank over the course of the loan or if you pay $200,000. Interest rates also tell you what it will cost to carry a balance (aka. not pay off) from one month to the next on your credit card. The higher the interest rate, the more you’ll pay.

What is an interest rate?

An interest rate is basically a fee you pay to be allowed to borrow money. It’s always a percentage of the total amount borrowed. 

As interest rates rise, the cost of borrowing rises with it. When borrowing becomes more expensive, that impacts everything and everyone, from everyday people to large businesses.

Lenders charge an interest rate because they want to be compensated for taking the risk of lending people money. This is why interest rates can vary based on your credit score. If you have a high credit score - meaning you have a history of responsible credit use - then you’re usually offered a lower interest rate than someone with a lower credit score. The riskier the borrower, the more the lender needs to be paid to make the transaction and the risk worthwhile.

However, a low interest rate is not always good because sometimes you are the lender. This is the case when you make a deposit into a savings account or a certificate of deposit (CD). In this scenario, you are giving a bank or a financial institution the use of your money. In return they must compensate you financially. In recent months the Federal Reserve has raised interest rates. This is good news if you plan to put your money in a savings account or CD because it means that you’ll earn more. For example, in early 2023, some 1-year CD rates are as high as 4.50%.   

What is a simple interest rate?

A simple interest rate is a specific way of calculating interest rate expense. You’ll know that the bank is using this calculation because they’ll refer to it as a “simple interest” in the terms they provide you.

The simple interest calculation is:

Simple interest = principal X interest rate X time

The principle is the amount of the loan.

For example:

Fred and Elliot take out a loan of $200,000 from their bank at a simple interest rate of 5% with a 15-year term, then the simple interest calculation is:

$200,000 X 5% X 15 = $150,000

This means that over the course of the loan Fred and Elliot will pay a total of $150,000 in interest. Therefore, the total cost of the loan is $200,000 + $150,000 = $350,000. 

What is a compound interest rate? 

Compound interest requires the borrower to pay interest on the principal and on the accumulated interest paid during previous periods. Some refer to this as “interest on interest.” 

Compound interest is more expensive than simple interest because with simple interest you’re always paying a percentage of the same number. But with compound interest you’re paying interest on a number that keeps getting bigger. As a result, the interest payments - in dollar value - keep getting bigger also.

Using the same numbers from the above example:

Fred and Elliot would pay a total compound interest of $215,783 instead of the simple amount of $150,000. The below formula shows you how compound interest is calculated, but there are many quick and easy free online calculators that can do the math for you.

Compound interest = P X [(1 + interest rate)n − 1]

P = principal

n = number of compounding periods​

What is APR?

APR stands for “annual percentage rate.” 

APR is always a percentage and it answers the question, “what percentage of the principal will I pay each year?” 

Or, in the case of an investment, it represents the income you earn. 

The benefit of an APR is that it makes it easy for borrowers to make an apples-to-apples comparison between different offers because the percentage includes any fees or costs that are part of the transaction. Importantly, ARP doesn’t account for compounding.

The two kinds of APRs are:

1. Fixed APR: A constant rate that doesn’t change throughout the life of the loan or agreement.

2. Variable APR: A rate that can change at any time.

Although the APR makes it easy to compare one offer to another, it’s important to remember that credit card companies often have different APRs for different transactions. Some of the different types of APR include:

• Purchase APR: 

The APR applied to your credit card purchases. This is often the first APR consumers look at when comparing credit card offers.

• Intro APR: This is a low APR that is intended to encourage you to apply for a credit card. Some intro APRs are as low as 0% and can be great if your first purchase is a big one. However, this APR will rise after the intro period ends. 

• Balance transfer APR: 

The APR applied to transfers from one card onto another. Sometime, though not always, this APR is higher than the purchase APR.

• Balance transfer APR: 

A penalty APR might be charged if you don’t pay the minimum amount due for 60 days. The penalty APR will almost always be much higher than the purchase APR but cannot exceed 29.90% by law.

How are interest rates decided?

Stay with us here, this is a little complicated. The short of it is that the US government controls certain variables that in the long term affect interest rates.

Generally, credit card interest rates follow the rise and fall of U.S. Federal Reserve interest rates. But the two numbers are not equal because the Fed doesn’t actually control credit card interest rates. Instead, they control the “target range” for the Federal Funds Rate. This is the rate banks charge and pay each other to lend money back and forth in the short-term. In recent months the Fed has increased this rate aggressively which makes the cost of borrowing more expensive than it has been in a while. This rate is usually about 3 percentage points lower than something called the “prime rate.”

The prime rate is the rate banks charge their best, or “prime”, customers. This is the credit card company’s starting point when determining the interest rate they’ll charge you. 

From here, the credit card company decides if they’ll add a “default margin” to the prime rate. This decision is based on your credit score. If you have a low score then the credit card company is likely to charge a higher margin. If your score is high, they will likely charge a smaller margin. 

Basically, the credit card company charges more interest to those with lower scores and less interest to those with higher scores. 

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