Whether you’re borrowing money from a lender or depositing money in a savings account, interest rates will play into your financial picture. And understanding exactly how they work is crucial to making the best possible decisions for your money.
Here’s the scoop.
Interest Rate Definition
Interest rate is the cost of borrowing or the payoff of saving. Specifically, it refers to the percentage of interest a lender charges for a loan as well as the percentage of interest earned on an interest-bearing account or security.
Interest rates change frequently, but the average personal loan interest rate is dependent on several factors, including the amount borrowed, credit history, and income, among others. A borrower with an excellent credit score and a dependable income, for instance, will likely be considered low risk and may be offered a lower interest rate. On the flip side, some vehicles like payday loans are considered riskier for lenders and tend to have higher interest rates.
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How Interest Rates Work
Whether you’re borrowing or saving money, the interest rate is applied to the balance during set periods of time called compounding periods.
For borrowers, this extra charge can add to outstanding debt. For savers, savings interest can be one way to earn money without much effort.
Let’s look at some specific examples.
You might take out a personal loan with an APR of 5.99%. That means you’ll pay an additional 5.99% of the loan balance each year in addition to the principal payments, which is paid to the lender for servicing the loan.
Or, if you hold a high-yield savings account that offers a 1% APY return, you can expect that account to grow by 1% of its balance each year.
Of course, the interest you might earn in a savings account is usually substantially lower than what you might earn on higher-risk investments.
And when it comes to any of the multiple uses of a personal loan, paying interest means you’re paying substantially more than you would if you were able to cover the expense out of pocket.
Fixed vs Variable Interest Rates
Lenders charge fixed or variable interest rates. What’s the difference between the two? Let’s take a look.
As the name suggests, fixed interest rates remain the same throughout a set period of time or the entire term of the loan. Fixed rates can be higher than variable rates. Borrowers who prefer more predictable payments — or are borrowing when interest rates are low — may decide to go with a fixed-rate loan.
|Pros of Fixed Interest Rates||Cons of Fixed Interest Rates|
|Rates won’t increase||Fixed rates can be higher than variable rates|
|Predictable monthly payments||Borrowers would need to refinance to get a lower rate, which may involve paying more in fees|
|Consistent payment schedule can make budgeting easier||Borrowers won’t benefit if interest rates decrease|
Variable interest rates change periodically, depending on changes in the market. This means the amount of your payments will vary. Generally speaking, variable-rate loans can be riskier for consumers, so they tend to have lower initial rates than fixed-rate loans. However, it’s important to note that when interest rates rise, so can the cost of borrowing. When borrowers decide to renegotiate from a variable-rate to a fixed-rate loan, they may face additional fees and a new loan length.
A variable-rate loan may be a good move for borrowers who plan to pay off the loan quickly or can take on the risk.
|Pros of Variable Interest Rates||Cons of Variable Interest Rates|
|Monthly payments may go down when interest rates decrease||Interest rates fluctuate depending on changes in the market|
|Rates can be lower (at first) than fixed-rate loans||Repayment amounts can vary, which can make budgeting difficult|
|Borrowers may receive better introductory rates when taking out a loan||May face extra fees and extended payoff time if you renegotiate to a fixed-rate loan|
Types of Interest
While all interest does one of two things — accrue as a result of saving money or in payment to the bank for a loan — it can be calculated and assessed in different ways. Here are a few common types of interest rates explained.
Simple interest is interest that is calculated, simply, based on the balance of your account or loan. This is unlike compound interest, which is based on the principal balance (the original money you borrowed) as well as interest accrued over time.
Most mortgages and auto loans are calculated using simple interest. That means you won’t pay additional interest on any interest charged on the loan.
For example, let’s say a driver takes out a simple interest loan to pay for a new car. The loan amount is $31,500, and the annual interest rate on the loan is 4%. The term of the loan is five years. The driver will pay $580.12 per month. After five years, when the loan is satisfied, they will have paid a total of $34,807.23.
Compound interest, on the other hand, means that interest is charged on not only the principal but also whatever interest accrues over the lifetime of that loan.
Say you take out an unsecured personal loan in the amount of $20,000 to pay for home remodeling. The loan is offered to you at an interest rate of 6.99% compounded monthly, and you must also pay an upfront fee of $500 for the loan. You’ll pay it back over the course of five years.
Over the course of those 60 payments, you’ll pay $3,755.78 in interest, not including the $500 extra you paid in fees. Each month, you’ll pay back some of the principal as well as the interest charged to you.
By the time you’re done with your home remodel, you’ll have paid $24,255.78 altogether, and that’s on a personal loan with a fairly low rate. In other words, you’ll have paid 20% more for the project than you would have if you’d funded it out of pocket.
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Amortizing loans are common in personal finance. If you have a home loan, auto loan, personal loan, or student loan, you likely have an amortizing loan.
Amortization is when a borrower makes monthly (usually equal) payments toward the loan principal and interest. Early payments largely go toward the calculated interest, while payments closer to the end of the loan term go more toward the principal.
The interest on an amortized loan is calculated based on the balance of the loan every time a payment is made. As you make more payments, the amount of interest you owe will decrease.
To see how payments are spread out over the life of the loan, borrowers can consult an amortization schedule. A mortgage calculator also shows amortization over time for a loan.
But here’s a look at a sample calculation:
Let’s say you take out a $200,000 mortgage over 10 years at a 5% fixed interest rate. Your monthly payments will be $2,121.31. Next, divide the interest rate by 12 equal monthly payments. That equals 0.4166% of interest per month. This means that in the first month of your loan, you’ll pay $833.33 toward interest and the remaining $1,287.98 toward your principal.
Now, how about the second month? To calculate what you’ll owe, deduct your monthly payment from the starting balance. (This will give you the “balance after payment” for the chart.) Be sure to add to the chart the $833.33 you paid in interest and the $1,287.98 you paid toward the principal. Repeat the calculation of monthly interest and principal breakdown for the rest of the chart, which includes 12 months of payments.
|Date||Starting Balance||Interest||Principal||Balance after payment|
Loans that calculate interest on a pre-computed basis are less common than loans with either simple or compound interest. They’re also controversial and have been banned in some states. Precomputed interest has been banned nationally since 1992 for loans with terms longer than 61 months.
This method of computing interest is also known as the Rule of 78 and was originally based on a 12-month loan. The name is taken from adding up the numbers of the months in a year (or a 12-month loan), the sum of which is 78.
Interest is calculated ahead — precomputed — for each month and added to each month’s payment, giving more weight to interest in the beginning of the loan and tapering off until the end of the loan term. In the case of a 12-month loan, the first month’s interest would be 12/78 of the total interest, the second month’s interest would be 11/78 of the total interest, and so on.
Here’s an example: Let’s say a borrower takes out a personal loan with a 12-month term that will accrue $5,000 in interest charges. According to the Rule of 78, here’s what the borrower would pay in interest each month:
|Month||Fraction of total interest charged||Monthly interest charge|
A loan with precomputed interest has a greater effect on someone who plans to pay off their loan early than one who plans to make regular payments over the entire life of the loan.
APR vs APY
Whether compound or simple, interest rates are generally expressed as APR (Annual Percentage Rate) or APY (Annual Percentage Yield). These figures make it easier for borrowers to see what they can expect to pay or earn in interest over the course of an entire year of the loan or interest-bearing account’s lifetime.
However, APY takes compound interest into account, whereas usually APR does not — but on the other hand, APR takes into account various loan fees and other costs, which APY might skip.
|APR (Annual Percentage Rate)||APY (Annual Percentage Yield)|
|Expresses what you pay when you borrow money||Expresses what you earn on an interest-bearing account|
|Factors in base interest rate over the course of one year||Factors in base interest rate over the course of one year|
|Factors in fees and other loan costs||Does not factor in fees and other loan costs|
|Does not factor in compounding||Factors in compounding|
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How Are Interest Rates Determined?
Lenders use several factors to determine the interest rate on a personal loan, including details about your financial background and about the loan itself. What kind of financial questions can you expect?
When lenders talk about a borrower’s creditworthiness, they’re usually referring to elements of your financial background. This may include:
• Your credit history
• Your income and employment
• How much debt you already have
• Whether you have a cosigner
The loan terms can also affect the rate. For example, personal loan rates can be affected by:
• The size of the loan
• The duration of the loan
Loan term is something borrowers should be thinking about as well. A longer loan term might sound appealing because it makes each monthly payment lower. But it’s important to understand that a longer-term loan may cost you significantly more over time due to interest charges.
💡 Quick Tip: In a climate where interest rates are rising, you’re likely better off with a fixed interest rate than a variable rate, even though the variable rate is initially lower. On the flip side, if rates are falling, you may be better off with a variable interest rate.
Interest Rates and Discrimination
Generally speaking, the higher your credit score and income level, the easier it is to qualify for loans with better terms and lower interest rates — which, of course, can make it more difficult for people in lower socioeconomic positions to climb their way out.
Discriminatory lending has had a long history in the U.S. Before federal laws protecting against discrimination in lending practice, lenders would regularly base credit decisions on factors such as applicant’s race, color, religion, sex, and other group identifiers rather than their creditworthiness.
The practice of “redlining” was begun in the 1930s as a way to restrict federal funding for neighborhoods deemed risky by federal mortgage lenders. It persisted for decades, and the detrimental effects can still be felt today by residents of minority neighborhoods.
Since residents of redlined neighborhoods were excluded from approval for regular mortgage loans, they were forced to look for other financing options, which were often exploitive. If they could not find any lender willing to loan to them, they continued renting, unable to gain equity in homeownership.
The interest rate is the cost of borrowing money — it’s a percentage of the total amount of the loan. It can also refer to the rate at which interest is earned on money in a savings account, certificate of deposit, or certain investments. The amount of interest you’ll pay is usually expressed using percentages, which will be listed as either APR (Annual Percentage Rate) or APY (Annual Percentage Yield), depending on which kind of financial product you’re talking about.
Lenders charge fixed or variable interest rates. Fixed interest rates remain unchanged for a set period of time or for the life of the loan, and may be a smart choice for borrowers who want a predictable payment schedule or are taking out a loan when interest rates are low. Variable interest rates can change depending on the market, which means the payment amount will vary. Though potentially riskier, these loans may offer lower initial rates. However, when interest rates rise, so can the cost of borrowing.
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.
What is the definition of interest rate?
An interest rate is expressed as a percentage and is used to calculate how much interest you would pay on a loan in one year (APR), or how much you would earn on an interest-bearing account in one year (APY).
What is an example of an interest rate?
Simple, compound, or precomputed interest rates are types of interest rates commonly used.
What is the difference between interest and interest rate?
Interest is the money you’re charged when you take out a loan — or earn for leaving your money in a deposit account to grow. Interest rate is the percentage you’re being charged or are earning.
What happens when interest rates are high?
Interest rate increases tend to lead to higher interest rates on personal loans, mortgages, and credit cards. It can also mean costlier financing for borrowers.
Can you adjust the interest rate on a personal loan?
Possibly. One way to lower the interest rate on a personal loan is to refinance it with another lender.
Photo credit: iStock/Remitski
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