What is an Interest Rate?
Interest rates show up almost everywhere in personal finance. They affect the cost of credit cards, auto loans, mortgages, personal loans, and other borrowing, while also determining how much your money can earn in savings accounts, certificates of deposit, and other interest-bearing accounts.
The rate itself is only one number, but it can have a substantial effect on the amount of money you pay or earn over time. Understanding how rates work gives you a way to compare financial products instead of looking only at the monthly payment.
What Is an Interest Rate?
An interest rate is the percentage charged on money you borrow or paid on money you
deposit.
For example, if you borrow $10,000 at a 6% interest rate, the lender charges interest for allowing you to use that money.
The amount of interest you pay depends on the balance, the rate, how the interest is calculated, and how long you keep the debt.
The same concept works in your favor with savings. If you put money into an interest-bearing savings account, the financial institution pays you interest for keeping your money there.
The percentage itself is only part of the story. A lower interest rate can reduce the cost of a loan, while a higher rate can make the same purchase considerably more expensive.
Term | What It Means |
Interest Rate | The percentage charged when you borrow money or paid when you keep money in an interest-bearing account. |
Principal | The original amount of money borrowed or deposited, before interest is added. |
APR | Annual Percentage Rate. It generally reflects the interest rate plus certain fees and costs associated with borrowing. |
APY | Annual Percentage Yield. It shows how much you can earn on a deposit account over a year, including the effect of compounding. |
Fixed Rate | An interest rate that stays the same for the agreed-upon period. |
Variable Rate | An interest rate that can change based on the terms of the loan or account. |
Compound Interest | Interest calculated on the original amount plus previously accumulated interest. |
Grace Period | A period when you may avoid interest on certain purchases by paying the statement balance in full by the due date, depending on the account's terms. |
Why Your Interest Rate Matters
Your interest rate can depend on several factors, including your credit history, the type of loan, the loan term, the lender, the amount borrowed, whether the loan is secured by property, and current market conditions. The interest rate itself can determine how much money you owe, or receive, over time.
When you borrow: interest is a cost.
When you save: interest is earnings.
Suppose two people each borrow $20,000 for five years:
5% Rate | 10% Rate | |
Amount borrowed | $20,000 | $20,000 |
Term | 5 years | 5 years |
Approx. monthly payment | $377 | $425 |
Approx. total payments | $22,646 | $25,496 |
Approx. interest paid | $2,646 | $5,496 |
The person with the 10% rate borrowed exactly the same amount for exactly the same amount of time but paid roughly $2,850 more in interest.
This is why comparing rates matters before taking out a loan. A monthly payment can look affordable while the total cost of the loan tells a very different story.
You may also see the term APR (Annual Percentage Rate) when comparing loans. An interest rate tells you the rate charged on the borrowed money, while APR generally reflects the interest rate plus certain loan costs and fees. APR can give you a better picture of the overall cost when comparing certain types of credit.
Fixed vs. Variable Interest Rates
A fixed interest rate stays the same for the period covered by the agreement.
If your car loan has a fixed 6% rate, the rate itself does not change during the loan.
A variable interest rate can change according to the terms of the account.
The rate may be tied to an index or benchmark, meaning your payment or interest cost could increase or decrease as that rate changes.
Credit cards commonly have variable rates. This matters because carrying a balance can become more expensive if your rate increases.
When comparing a loan or credit account, look beyond the starting rate. Check whether the rate can change, when it can change, and how the change could affect your payment.
Credit Cards: Where Interest Gets Expensive
Credit cards work differently from many installment loans because you can borrow, repay, and borrow again as long as you have available credit.
If you pay your statement balance in full by the due date and your card has a grace period that applies to purchases, you can generally avoid interest on those purchases. If you carry a balance, interest can be charged according to the card's terms.
For example, suppose you have a $3,000 balance on a credit card with a 24% annual interest rate.
That's a much more expensive form of borrowing than a 5% or 6% installment loan.
Making only the minimum payment can keep the account current, but it can also stretch repayment over a long period and result in substantial interest charges.
This is one reason the interest rate on a credit card deserves attention even when the minimum payment looks manageable.
Interest Can Also Work in Your Favor
Interest isn't always something you pay.
Savings accounts, certificates of deposit, money market accounts, and some other deposit products can pay you interest on your money. The rate you earn is one factor to compare when deciding where to keep your savings.
You may also see APY (Annual Percentage Yield) on deposit accounts. APY takes compounding into account, making it useful when comparing how much different accounts can actually earn.
For example, if you keep $1,000 in an account earning interest, the bank can pay interest on that balance. If the interest is added to your account, future interest may be calculated on the larger balance. Over time, this is known as compound interest.
The same basic idea works in reverse with debt. Interest can compound or otherwise accumulate according to the account's terms, making unpaid debt more expensive over time.
Final Thoughts
Interest rates affect both sides of your financial life. They can add to the cost of borrowing or help your savings grow.
Before accepting a loan or opening a credit account, look at the interest rate, APR when applicable, whether the rate is fixed or variable, fees, and the total amount you will repay. For savings, compare the interest rate and APY along with any account requirements or fees.
Understanding these numbers gives you a better idea of what you're actually agreeing to instead of looking only at the monthly payment or advertised rate.
Up Next: You know what an interest rate is. Next, we'll look more closely at Annual Percentage Rate and how it differs from standard interest.
Pardon our ads, they allow us to keep our site running and keep our helpful content free to access.
Comments