What Are Interest Rates, and How Do They Work?

By: , Contributor

Published on: Jan 04, 2020 | Updated on: Feb 07, 2020

From APRs to their impact on the economy, interest rates can seem complicated. Let this guide simplify things.

Understanding what interest rates are and how they work is an important part of managing your finances. If you have any type of debt, including credit cards, student loan, car loan, or a mortgage on a property, the interest rate affects how much you pay over the life of the loan. This article explains what interest rates are, how interest rates work, and how interest rates relate to APR and the economy.

What is an interest rate?

When someone borrows money, the initial loan amount, also known as the principal is repaid over time in addition to interest, which is the cost lenders charge for borrowing money. The higher the interest, the higher the cost of borrowing money.

Lenders commonly charge higher interest rates to less credit-worthy borrowers and lower interest rates to those with higher creditworthiness because they are more likely to repay the debt. Anyone who is loaning money can charge interest, although there are usury laws limiting how much interest can be charged depending on the type of loan.

How is interest applied in a loan?

Interest is applied to the unpaid principal balance of a loan. The type of debt you have affects the type of interest you pay. Interest can be:

  • Fixed: This is a set, designated interest rate that never changes. The most common example would be a 30-year fixed-rate mortgage.
  • Adjustable or variable: This interest rate adjusts periodically and is typically tied to an index such as the prime rate (the rate banks change their most creditworthy customers, like large corporations). For example, your interest rate may start at 4% but after six months adjust to 4.5%. A new principal and interest payment is calculated considering your new interest rate and the unpaid balance at the time the loan adjusts.

The most common examples are commercial loans or home equity lines of credit (HELOCs).

Interest-only: Only the interest is paid on the loan until a set date, at which time the entire principal amount is due. The principal is not reduced in the normal payments. Interest-only is commonly used in private lending and is less popular in mainstream lending.

Most real estate loans are amortized (reduced with payments) over a period of time, such as 10, 15, 25, or 30 years, with the monthly payments and interest repaid first -- meaning a large portion of your payment will be applied to interest before the principal.

For example, if you received a 30-year 4% fixed-rate mortgage for $100,000, over the entire 30 years you would pay $171,867.97 in total -- $71,867.97 in interest and $100,000 of principal.

Your monthly principal and interest payment would be $477.42, with the majority of that payment being applied toward interest at the beginning of the loan and toward the principal in the final years of the loan.

Payment Principal Interest
First $144.09 $333.33
Halfway $261.41 $216.01
Last $475.84 $1.58

The shorter the period of the loan, typically the less interest is paid even if the interest rate is higher. For example, a $100,000 15-year fixed-rate loan at 6% interest would equate to $51,893.80 in interest, which is still less than the example above, although there is a breaking point. Knowing how to quickly compare loans and calculate the interest that you pay over time helps you determine which loan may be a better option for you.

Since interest is only charged when there is an unpaid balance, credit cards only charge interest if there is a balance at the end of the month or billing cycle. Interest is then calculated on a daily interest rate rather than an amortized rate or annual rate. Balances on credit cards require at minimum the interest to be paid each month, although paying more than the minimum required amount will help pay down the principal balance.

What is an APR?

The annual percentage rate (APR) is a more accurate representation of the cost of the loan because it includes any additional lending fees, private mortgage insurance, or points. The APR gives you a better indication of the total cost for borrowing money, while the interest rate is what is used to calculate your monthly payment. A loan may have a fixed interest rate of 4%, giving you a slightly lower monthly payment, but an APR of 4.25%.

How do interest rates impact economic growth?

In the United States, the Federal Reserve sets the standard for interest rates, which ultimately impacts the bond market, stock market, real estate, and the economy as a whole.

When the cost of borrowing money is low, economic activity is spurred. People spend more and borrow more, real estate prices increase because of an increase in buyers, and businesses expand because of additional capital. Conversely, higher interest rates mean the burden for borrowing money is greater, leaving the borrower with less money left over to spend, slowing economic activity.

The Federal Reserve (the Fed) adjusts interest rates to slow or speed up economic activity. In 2019, the Fed lowered interest rates three times nearing record low interest rates making this an ideal time to borrow money because of the low cost.

The bottom line

There are amortization calculators that can help you determine the total cost of a loan including the interest rate, APR, and monthly payment amount. This can be useful when comparing different loan offers or as you try to consolidate debt.

It's important to understand how interest rates work so you can calculate the cost of your debt. Knowing how much interest you are paying over time can help motivate you to seek lower interest rates elsewhere or pay off debt at a faster rate.

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