Going into debt can cost you more money than you originally borrowed. That's because most lending and credit systems involve interest rates, where a percentage of what you borrowed is added to your balance over time.
Understanding how interest rates work and the factors that affect them can help you manage your money better and make more savvy borrowing decisions. Let's discuss interest rates for loans and credit cards, types of rates you might encounter and how they're set.
What is an interest rate?
An interest rate is the cost of borrowing money, expressed as a percentage of the loan amount. It's the price you pay for the convenience of using someone else's money. Just like any other price, interest rates can vary depending on several factors, including your creditworthiness and the type of loan.
How do interest rates work for loans and credit accounts?
Banks, credit card companies and other creditors have expenses, so they generally don't lend money for free. Charging interest helps them ensure they can continue to offer lending services.
The basics of interest involve adding on a percentage of your borrowed amount (the principal) to arrive at your balance due. A simple example is if you asked a friend to borrow $50 and they agreed but said that if you don't pay them back by next Friday, they'll add $5 per week until you do. If you pay them back right away, you may not face any interest charges. But if you wait two weeks, you owe $60.
Interest rates can quickly get more complex, however, when other factors in the calculation change. Any time you are borrowing or using credit, it's essential to know:
- The rate and if it's fixed (set for the whole term) or variable (changes based on the market)
- When interest will be charged—annually, monthly, weekly, daily, etc.
- Whether interest accumulates on just the amount you owe or on the running total that includes previous interest and fees
These factors can make a big difference in what you ultimately end up paying. Here's a look at how changing those factors could affect borrowing $1,000 for three months (not including any payments):
| Amount borrowed | $1,000 | $1,000 | $1,000 |
| Interest rate | Fixed at 10% | Fixed at 10% | 10% for first month, then 20% |
| Interest period | Monthly | Monthly | Monthly |
| Interest charged on | Principal only | Principal + Interest | Principal + Interest |
| Calculation | Month 1: $1,000 + ($1,000 x 10%) = $1,100 Month 2: $1,100 + ($1,000 x 10%) = $1,200 Month 3: $1,200 + ($1,000 x 10%) = $1,300 | Month 1: $1,000 + ($1,000 x 10%) = $1,100 Month 2: $1,100 + ($1,100 x 10%) = $1,210 Month 3: $1,210 + ($1,210 x 10%) = $1,331 | Month 1: $1,000 + ($1,000 x 10%) = $1,100 Month 2: $1,100 + ($1,100 x 20%) = $1,310 Month 3: $1,320 + ($1,320 x 20%) = $1,584 |
| Total after 3 months | $1,300 | $1,331 | $1,584 |
Types of interest rates explained
How interest rates are calculated and set depends on both the kind of lending product and other factors in the financial world. Here are a few you might encounter and what they mean for your loan's costs.
Simple interest vs. compound interest
A compound interest rate assesses how much you owe on both the principal and the accrued interest. The most common example of this is credit cards with charges that aren't paid off every month. Let's say you charge $500 to a card that charges an 18% interest rate every monthly billing cycle. If you pay all $500 on or before the due date, you aren't charged interest. But if you send in only $200 of payment, interest will be calculated for the remaining $300, making your balance the next month $354. If the next month you send in just $100, interest will be charged on the remaining $254 (which includes $54 of interest from before), compounding it into a balance due of $299.72 for the following month.
You can see how compound interest can be difficult to escape if you aren't paying down the balance as much as possible each time a payment is due.
APR vs. APY
An annual percentage rate (APR) is essentially the simple interest rate—it doesn't take into account the impact of compounding. The annual percentage yield (APY) factors in how frequently your interest is compounded. The difference between APR and APY is greater when your interest is compounded more frequently.
Here's an interest rate example for a car loan with compounding interest. Consider a $10,000 car loan that offers a 5% APR. If the interest was simple, you'd only be charged $500 in that first year, and your APR and APY would be equal. But if the interest is compounded daily, you'd accrue an additional $12.67 due to that compounding, meaning that despite your 5% APR, your APY is actually 5.13%. Over a multi-year car loan, compounding interest can start to add up, so it's good to know your actual APY so you can calculate the true cost of your car over time.
Fixed rate vs. variable rate
Lenders and creditors may offer fixed or variable interest rates. With a fixed rate, you lock in a certain interest rate at the time of your loan. You pay that rate regardless of any new rate offers the institution may have afterward. If rates drop after you secure the loan, you might regret being stuck with a higher rate than other borrowers. But at times
Variable rates adjust in response to the wider market to align with what the prevailing rate is. You may start with the going interest rate, but it can go up or down based on how the lender or creditor perceives competitive interest rates at the time. Variable interest rates are often used with credit cards and home equity lines of credit and sometimes mortgages and personal loans. Credit cards in particular may offer a low introductory rate (sometimes even 0%) that goes up to the market rate (often ranging from 18%-25%) after several months, a year or more.
People tend to select the fixed rate or the variable rate based on their expectations for the near- and medium-term future. If you expect rates to rise, a fixed rate lets you keep a low rate going forward. But if you expect rates to fall, a variable rate allows you to only pay the current high rates for a short time before it adjusts in response to lowering rates.
How are lending rates set?
Most lenders and creditors will first look at the interest rates established by the Fed. Banks decide how much to borrow from the Fed to make a variety of kinds of loans and investing choices. So when the Fed lowers or raises its rates, all the other rates tend to change in response.
One key rate is the prime interest rate, or the rate charged by commercial banks to their lowest-risk and most creditworthy customers. Knowing how the prime interest rate has been moving recently can give you some context for the kinds of rates you're offered as an individual borrower.
Why interest rates vary among institutions
While lenders and creditors set their rates with the Fed and prime rates in mind, they also adjust based on the conditions they're experiencing now and expect in the future. Many institutions set their interest rates based on what they think their audience of borrowers can tolerate. That's why interest rates are highly competitive.
Ultimately, several factors go into how lenders and creditors determine what their rate will be, both generally and for individual borrowers, including:
- What the loan or line of credit is for
- How much you borrow
- How long before you plan to pay it back
- How likely you are to pay it back
- What they're risking if you don't pay it back
- Where the Federal Reserve has set rates
- What others are charging for similar borrowing
When you're trying to get the lowest interest rates for borrowing, it helps to have
