What is an Interest Rate?
An interest rate is a percentage rate used in the world of loans and represents the cost of borrowing money. For lending you money, lenders will charge a percentage of the principal amount they loaned to you.
Let’s say you took out a loan of $1,000. If the interest rate was 10% per year, you would owe the $1,000 you took out as a loan and you would owe $100 in interest. So, if no payments were made for the year, you would owe a total of $1,100 at the end of one year.
Interest rates can vary from high to low depending on many factors:
- Loan type
- Credit score
- Loan amount
- Loan term
- Down payment
- Interest rate type
Why Do Interest Rates Matter?
Interest rates matter because they determine the cost of borrowing.
The cost of borrowing is important for a consumer to know because consumers borrow for many large purchases throughout their lives for things including education, cars, and homes.
Higher interest rates on a loan lead to higher amounts of interest owed for a given period of time.
By knowing what an interest rate is, you can use the rate to make smarter financial decisions when borrowing or lending.
You’ll know what an appropriate rate looks like and identify an attractive or unattractive rate.
Interest rates can be charged on any transaction that requires the borrowing of money. This includes you receiving a loan or lending money out to someone else, like a bank for example.
Examples of Where Interest Rates are Involved
- Funds used for personal use
- Interest rate range: 7% to 36%
- Funds used to purchase a home
- Interest rate range: 2% to 7%
- Term of loan, along with other factors, impact the rate
- Funds used to pay for tuition and education expenses
- Interest rate range for federal loans: 5% to 7%
- Interest rate range for private loans: 3% to 14%
- Funds used to purchase a car
- Interest rate range: 3% to 10%
Loans for consumer goods
- Funds typically used for large purchases on consumer goods, such as appliances for your home
- Interest rate range: 5% to 10%
- When you lend the bank money in the form of a savings account, they pay you interest for you letting them hold your money
- Interest rate range: 1% to 3%
As you see from above, interest rates can be highly variable. It is important to note that the interest rate ranges above vary based on several factors mentioned in the intro including:
- Loan type
- Credit score
- Loan amount
- Loan term
- Down payment
- Interest rate type
How to Get the Lowest Interest Rates
When taking out a loan, a big focus of yours will be to find the lowest interest rate possible (but not at the expense of the other factors). Given that the other aspects of the loan are attractive, focusing on receiving the lowest interest rate is important because the lower the rate, the lower the cost of borrowing.
Imagine you take out a loan for $100,000. If your interest rate is 10%, you will pay $10,000 in interest. If you can get that same loan amount at a 5% interest rate, you will only pay $5,000 in interest and will save $5,000.
On top of that $5,000 in savings, your monthly payment on your loan will be a lot lower as well, further decreasing the financial burden that borrowing money can cause.
Here are ways to put yourself in the best position to receive low interest rates:
- Increase your credit score
- Get quotes on rates from multiple lenders and negotiate a lower rate
- Use a larger down payment from the beginning (ex: car and home loans)
- Build a record of employment
- Use a co-signer
- Sign up for autopay if a discount is offered
- Opt for a shorter payment period
- Survey interest rate options (Ex: fixed, variable, etc)
Just as Important as the Interest Rate
The interest rate on its own is not the only thing that matters. The context of the rate is just as important.
You need to look at what an interest rate is being applied to and how it is being applied. Many times, interest rates on offers look attractive from the start but can end up leading to a financial catastrophe if you do not fully read the terms of a loan.
Always read past the initial offer that reeled you in and understand the terms and financial impact.
Things You Should Look at When Borrowing and Questions to Ask
- What is the rate?
- Is the rate for monthly or annually?
- How was this rate determined?
- Can I get a lower rate with my healthy credit score?
Interest rate type
- Is this a fixed interest rate or variable?
- How does the introductory interest rate differ from the regular rate of the loan?
- Is the loan for months or years?
- How many years is the loan for?
- Do I want to pay off the loan sooner rather than later?
- What dates are my payments due by?
- How many total payments will I make over the term of the loan?
- What is the total amount I will pay when this loan is fully paid off?
- How much will my monthly payment be?
- How much of my monthly payment goes towards paying down principal versus interest?
- What type of loan does this interest rate apply to?
- Are there benefits for one loan type versus another?
- When are my payments due?
- What date am I expected to fully pay off the loan amount by?
- When does the introductory period of 0% APR end?
Interest rate options
- Will the interest rate be higher or lower based on the term length of the loan?
- Do I pay interest every month or am I paying interest and principle?
- What interest rate option aligns with my financial goals and capacity?
Examples of the Different Types of Interest Rates
Annual Percentage Rate (APR)
- The annual percentage rate charged by a lender for borrowing money
- A fixed rate means the interest rate will remain the same over the term of a loan. If your beginning rate is 5%, you will pay 5% interest for the entirety of the loan.
- It’s benefit is always knowing what amount you’ll pay each month.
- Another benefit comes from taking advantage of a low interest rate environment. If underlying benchmark interest rates are low (ex: LIBOR or federal funds rate), you can lock in a low fixed interest rate. Then when interest rates rise, your rate will remain the low fixed amount.
- A variable interest rate fluctuates throughout the term of a loan based on the movement of interest rates on an underlying benchmark rate such as the LIBOR or federal funds rate.
- The benefit of a variable rate is that your rate could decrease from the original rate amount you signed for. If you took out the loan and the rate was at 6%, it is possible your rate could decrease to 4%.
- This variability is also a downside as well. If you signed up for an interest rate at 6%, that rate could creep up to 8%.
- With variable rates, your loan payment due each month can vary.
- Prime rates are interest rates given to preferred customers or those with the highest creditworthiness.
- If you have a high credit rating and pay your bills on time, you can be rewarded with lower rates since your are seen as a trustworthy borrower in the eyes of a lender.
- A nominal interest rate is the interest rate before taking inflation into account
- A real interest rate is the interest rate after taking inflation into account.
- Real interest rate = nominal interest rate – inflation
- If you take out a loan for $5,000 and the interest rate is 5% and inflation is 3%, the real interest rate you are paying is 2%.
Protecting Yourself Financially
Understanding interest rates, the context of interest rates, and the corresponding math behind them will allow you to protect yourself financially and make informed decisions when borrowing or lending to others.
Too often, consumers are lured in by attractive interest rates they see in advertisements. If an interest rate seems too good to be true, it probably is. There is always a catch and you need to thoroughly read the terms and details of any interest rate or loan you encounter.
As for lending, you’ll always want to lend your money out at an attractive interest rate. Whether it is a savings account, money market account, or a purchase of a bond, you will want to put your money somewhere to earn a high amount of interest for an associated level of risk.
Understanding interest rates is essential to financial literacy. It can work for you beautifully or work against you devastatingly.
Basic knowledge and consideration of interest rates and their implication is all you need to navigate your loans, savings, etc in a smarter manner.
When dealing with interest rates, make sure to consider the rest of the situation and terms as well. Don’t fall for the initial advertisements and claims.