Interest rates: Here’s how they work


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Shopping around for a loan or credit card makes one thing very clear: Borrowing money isn’t free. While the types of fees can vary, interest is generally a given.

In simple terms, interest is the amount you pay to a bank or lender to use the funds they are extending to you. On the flip side, it’s also what you might be paid for putting your money into an interest-bearing savings account or Certificate of Deposit (CD).

Here are a few facts you should know.

Types of Interest

Not all interest rates are calculated the same way or applied to the same type of financial products. Let’s take a look at a few of them.

Simple Interest

As the name implies, this type of interest is very basic – it’s a one-time calculation of the percentage of the original principal amount of a loan or deposit. This type of interest is most commonly used for auto loans, mortgages, and short-term personal loans.

Loan: $5,000
Term: 1 year
Interest rate: 12%
Total interest paid: 5,000 x 0.12 x 1 = $600

Compound Interest

Compound interest is calculated as a percentage of the original loan or deposit amount, plus the  accumulated interest. This can be calculated differently depending on the rate in which it compounds – daily, monthly, quarterly, annually. So while the actual rate may remain the same, the dollar amount paid will change as the balance changes.

This type of interest calculation is common for long-term personal loans, deposit accounts, and credit cards.

Here are a few other interest rates you might see mentioned that are important to note.

  • Prime Rate: The interest rate banks often charge their most credit-worthy customers, based on the current federal funds rate (or the rate banks charge other banks to borrow money).
  • Discount Rate: The minimum interest rate the Federal Reserve Bank charges financial institutions for loans.

These rates might not seem like they apply to you, but they do. Both the prime rate and discount rate are used as benchmarks, meaning they inform the rates offered to you as a consumer. If you are offered a variable interest rate, for instance, the change may be based on a change in the prime rate.

That brings us to another important difference in interest rates: fixed and variable.

If an interest rate is fixed that means it will remain the same for a set period of time or the entire time you carry a loan or line of credit. It will not change based on the prime rate or discount rate.

A variable interest rate is subject to change based on different factors, including the discount rate and prime rate. For example, an adjustable rate mortgage (ARM) may allow you to lock in a low interest rate initially then, after a set period of time, it will likely readjust to the current prevailing interest rate. You could also be hit with a higher interest rate if you become delinquent on your account.

Important Things to Know

Now that you know a few buzz words around interest rates, make sure you know these key facts.

Credit scores play an important role in interest rates. The higher your credit score the more confident a lender or creditor is likely to be that you will make payments in full and on time. This often results in lower interest rates and other more favorable terms. (See a breakdown from Bankrate of interest charges based on credit score.)

Revolving accounts tend to have higher interest rates. Revolving accounts — like credit cards — allow you to borrow money up to a certain amount (your credit limit), make payments, and borrow again. This flexibility in borrowing means greater risk for the creditor, potentially resulting in higher interest rates than other types of accounts (like mortgages, auto loans, and personal loans).

Credit cards can have multiple interest rates. Sometimes interest rates aren’t quite so straightforward. Credit cards, for instance, can have multiple interest rates that can all be applied for different transactions or reasons:

  • purchase rate
  • penalty rate
  • introductory rate
  • cash advance rate

Interest rates and Annual Percentage Rate (APR) are different.
While interest rates are a component of APR, they are not one and the same. APR is also calculated as a percentage and includes the interest rate plus any additional fees you may be charged annually to borrow money. For instance, your mortgage APR may include broker fees, discount points, and origination fees PLUS the interest rate charged.

How to Get the Best Interest Rates

Lower interest rates can mean big savings in the long run. If you want to improve your chances of getting the best rates, there are a number of ways to make it happen.

Improve your credit. Give your credit report and credit score a boost with these tips.

Ask. Did you know you can simply ask for a better interest rate? There’s no guarantee a lender or creditor will grant your request but it’s possible. If you’ve improved your credit that can be a good place to start the negotiations. It also may help to point out if a competitor is offering a better rate.

Shop around. From credit cards to mortgages there are a variety of financial products available and plenty of lenders and creditors to turn to. If you’re looking to score the best interest rate, make sure you shop around and see what is available — just make sure to follow these tips to protect your credit score in the process.

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