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What Is an Interest Rate?

An interest rate is defined as the percentage of principal the lender charges for using its money. Your interest rate will tell you how much to pay each month.

When you borrow money, the bank or lender you take money from requires interest for the use of their funds. Borrowing can include cash, goods, or assets, including homes, commercial buildings, and vehicles. Your interest rate is charged in addition to the principal payment.

How Do Interest Rates Work?

Usually, lenders require interest in return for borrowing their money. In short, interest rates will likely appear in various aspects of your life, so understanding the different types of interest and implications of them will be beneficial to your long-term financial goals.

Your interest will impact the overall price that you pay on your debt, once the loan is paid in full. Each lender will have a different rate that helps determine the actual amount you owe.

To sum up, before you borrow, become familiar with interest rates and how they can impact the overall total you pay over the course of your loan or investment.

What Is Interest? 

You probably know a few things about interest already, like the amount you borrowed is known as the principal balance of your loan. You likely already know that you have to pay interest on top of that as a fee for borrowing the money from the bank or lender. However, the harder part is to figure out how to calculate interest and how the interest rate is determined.

How To Calculate Interest Rates

Understanding how to calculate your monthly interest is an essential skill. Often, rates are quoted as annual percentage yield (APY) or an annual percentage rate (APR). However, most people like to think in terms of monthly costs, instead of annual costs.

For example, you pay your car payment, mortgage, and utility bills on a monthly basis. That is why many like to calculate their interest monthly, instead of focusing on the annual rate.

Calculating Monthly Interest Rate Example

To keep things simple, let’s assume that you pay an interest rate that is 10% per year and your principal payment is $1,000 per month.

  • First, you want to convert the annual rate from a percentage to a decimal. You do this by dividing by 100. 10/100= 0.10
  • Secondly, you divide the above number by 12. This will give you the monthly interest rate. 0.10/12=0.0083
  • Lastly, you’ll then calculate the monthly interest on your monthly principal amount. 0.0083×1,000= $8.30 monthly.

You now know your monthly interest on this payment. You can add that amount to your monthly principal payment, and now know what you will owe monthly. $8.30 + 1,000 = $1,008.30

To calculate your monthly interest rate as a percentage, you simply convert the monthly rate as a decimal format into a percentage by multiplying by 100. The monthly interest rate in our example is 0.83%

Impact of High and Low Interest Rates 

The interest rate on bank loans, credit cards, and mortgages is impacted by the Federal Reserve. The federal funds market provides banks and credit unions with surplus balances a space to lend the balances to institutions in need of balance increases. The reserve balances are held at the Federal Reserve and borrowed at a federal fund rate. This rate influences all other financial markets.

When the economy is struggling or in a financial crisis – like during the Great Recession – the Federal Reserve can lower the interest rates to nearly zero.

Typically, lower rates provide a surge in economic growth. The lower rates make borrowing money cheaper which encourages businesses and consumer spending.

Alternatively, when the Federal Reserve raises interest rates, the opposite occurs. As a result, there is less money that is lent because businesses and consumers do not want to borrow money at a higher rate. Their loans become more expensive, thus slowing down the economy.

Types of Interest Rates 

There are multiple forms of interest that you may come across. As a borrower, it is important to know the different types and how they might impact your loan. While the example above was showing fixed interest, not all interest rates are calculated the same.

Fixed Interest

Fixed interest is as straightforward as it sounds. You are charged a “fixed”, or specific, interest amount for a line of credit. This amount must be repaid with your principal. It is the most common form of interest, easy to understand, and easy to calculate.

Variable Interest

Fluctuating interest rates are called variable interest. They are usually tied to ongoing benchmark interest rates, depending on the type of loan or security. Variable interest can also commonly be called adjustable or floating interest and are commonly found in credit cards, corporate bonds, mortgages, and other loans or securities.

Compound Interest

Compound interest calculates interest based on the principal and already accrued interest. The loan interest is calculated annually, and the lender then includes the interest amount into your loan balance. Your next year interest payment will be calculated based on the principal, plus the interest earned in the year prior. Many accountants call compound interest “interest on interest.”

Prime Rate

Prime rate is the interest that lenders use with their most credit-worthy, or favorite, customers. The rate is based on the federal funds rate.

Amortized Rate

Amortized rates are common in home and car loans. They are calculated to have the borrower pay a larger percentage of the interest at the start of the loan. As time progresses, the amount of principal paid monthly will increase and the interest payment decreases.  

What Influences Interest Rates? 

Your interest rate is determined by various factors, including the federal fund rate outlined above. Your lender will review a variety of factors to assess the risk of lending to you as a borrower. The higher the risk, the higher your interest rate could be.

Here are a few factors that help lenders determine interest rates for consumers and business owners.

Credit Score

This one is quite simple, the lower your credit score, the higher your interest will be. The higher your credit score, the lower your interest rate will be.

Credit History

The bank or lender will look at your credit history to determine the repayment ability you have. If you have a troubled credit history, your interest rate could be higher.

Income and Employment Type

Your income and employment type are all factors that lenders look at to determine if you can pay back the loan you are requesting.

Loan Size

The bank will look at how much money you are asking for and determine what interest rate to charge for the risk. A smaller loan size can even lead to a slight increase in rate so the lender can make it worth their while.

Loan Type

The type of loan and interest types, mentioned above, all come with a variation of risks. Based on your financial situation, your interest rate could vary depending upon the type of loan you are seeking.

Understand Your Strategy Before Taking on Interest

To determine if a loan is right for you, take a look at the factors outlined above and make sure you have a strategy that can ensure a lower interest payment. You do not want to pay more interest than you have to.

Your financial advisor can help you reach your financial goals if you are unsure of where to get started and how to find the best lending options for your personal needs.