Interest is essentially the cost of borrowing money, usually expressed as a percent of the total amount borrowed.
The interest rate is the name we give the percentage charged (or earned) on borrowed money.
Say, for example, you lend me $100 with 5% simple interest to be paid back within the year. That means, when I pay you back, I’ll owe you a total of $105. $5 is the interest I paid as a fee for borrowing that money from you, and 5% is the interest rate on the loan.
You get that $5 to pay you for taking on the risk of lending money, in case for some reason I failed to pay you back, or inflation made $100 worth less by the time you got it back.
Interest rates are applied to just about every common lending or borrowing situation that occurs in a professional financial setting. Vehicle loans, mortgages, student loans, business loans, credit cards, and so on all have interest rates applied to them.
Interest rates are affected by the economy. They respond to the supply and demand of credit, inflation, and government monetary policy.
When it comes to your loans and payments, changes in interest rates can reflect in your personal finances. For example, loans with variable rates may see rate changes, or you may be able to save money through a well-timed refinance.
Read on for a more in-depth look at interest rates – what they are, how they work, and why they matter (even if you’re already locked into loans).
In this guide, you’ll get the answers to these Frequently Asked Questions about interest rates:
What are the kinds of interest rates?
What’s the difference between interest rate and APR?
Who determines interest rates?
What causes interest rates to go up and down?
How do interest rates affect car payments?
How do you know if market changes mean you could save money?
What are the reasons people consider refinancing?
Here are a few key terms to help you better understand loans and interest rates:
Simple interest
Compound interest
Prime rate
Fixed rate loans
Variable loans
APR
APY
Simple interest is interest that is applied only to the base amount borrowed or lent.
Simple interest percentages are charged on a per year basis, using the following formula:
Interest = principal x rate x term (in years)
So, let’s say you borrowed $100,000 at 4% to be paid back over the course of 5 years. With simple interest, you would pay:
$100,000 x 0.04 x 5 = $20,000
$20,000 in interest, meaning the total you’d have to pay back over the course of 5 years would be $120,000 – you’re paying back the principal plus the interest.
Compound interest is interest that’s applied to the base amount borrowed plus any interest owed from previous periods.
It’s calculated using the formula:
Interest = principal x (1 + rate)term – principal
So, taking the same lending scenario but making it compound interest, you’d have:
$100,000 x (1 + 0.04)5 – $100,000 = $21,665.29
That means you have $21,665.29 to pay in interest. Compound interest is more commonly used in business scenarios like investing.
The prime rate is a reference rate or base rate used by banks.
While each bank sets their individual base rate, resources like the Wall Street Journal typically take the average of recent rates from a wide group of major financial institutions to determine a U.S. prime rate.
The rate tends to fluctuate based on factors like the Federal Reserve’s federal funds rate.
Fixed rate loans are loans that have a set interest rate for the life of the loan.
Fixed rate loans are popular because they offer stability for budgeting and can protect you from market fluctuations. Their downside is that if rates go down, you don’t benefit, and they may come with more penalties if you want to repay your loan early or refinance.
Variable loans are loans where the interest rate can change based on prime rate fluctuations.
Most variable loans start with an introductory rate (usually a lower rate than comparable fixed rate loans) that remains fixed for 1, 3, or 5 years. After that, the rate will be adjusted to reflect the market roughly every 6 months.
While variable loans often start off more affordable and offer borrowers the chance to benefit if interest rates drop, they’re also more volatile and can result in much higher payments if rates go up.
APR, or annual percentage rate, is the total annual cost of borrowing money on a loan, expressed as a percentage.
The APR includes not just interest but also any fees on top of the interest. Many loans have other fees attached to them than just the interest rate, so it’s important to review your APR closely when taking out a loan or credit card.
APY, or annual percentage yield, is the total annual interest earned on an account.
Essentially, APR expresses the total amount you pay for money borrowed in a year, and APY expresses the total amount earned for money loaned, invested, or saved.
Banks and lenders determine their individual interest rates based on a variety of factors including: prime rates, the Federal Reserve’s federal funds rate, and the borrower’s unique financial picture.
The interest rates available to you individually may go up and down based on market rates, but will also be determined based on things like your credit score, income, and payment history.
Interest rates are tied to broader economic trends.
You’ll often hear about the Federal Reserve, or the Fed, setting rates, because the federal funds rate does set the tone for broader prime rates in the U.S. While the Fed is not solely responsible for interest rates, they do tend to adjust their rates up and down based on the economy.
The key factors they look at are:
Inflation
Employment data
Generally, lower rates mean more borrowing, so the Federal Reserve might adjust rates up to keep inflation in check, or they might lower rates when unemployment is high to stimulate the economy and help create more jobs.
Interest rates are reflected in any formal borrowing and lending, including vehicle loans.
If you have an auto loan and make a monthly car payment, then you likely have a fixed interest rate loan with a rate based on your downpayment, financial picture, and prime rates at the time you financed your car (plus, in many cases, dealership markups).
You should make sure you know your current loan rate and keep track of market changes.
If rates are lower than when you got your financing, you may be able to benefit from refinancing your loan(s).
Paying attention to prime rates can help you make money by investing when rates are high and financing or refinancing when rates are low.
However, federal and prime rate changes are not the only reason to consider refinancing. As well as lower market rates, you may want to look into refinancing if:
Your financial picture or credit score has improved
You financed through a dealership
Your monthly payment is too high and you need more favorable terms
You want to add or remove a co-signer
You want to change your loan terms to pay it off sooner (or later)
Refinancing a car loan is a common way to get a better deal and save money on car loan payments.
Interest rates are an integral part of the American economic ecosystem, and understanding them can help you make better financial decisions.
