As you explore the world of personal finance, you’ll find that interest rates can have a big impact on your finances. Although the differences in rates may seem small, you’ll find that a little swing can make a big difference. With that, it is critical to understand how they work.
Today we will take a closer look at interest rates and why they matter so much.
What are interest rates?
When you borrow money from a lender, you should expect to pay interest on the loan. The interest rate of the loan is applied to the principal of the debt – aka the amount of the loan.
The borrower will pay interest charges to the lender for the opportunity to borrow funding. Essentially, as the borrower, you are paying for the privilege of the loan. On the flip side, the lender is rewarded for providing you with the upfront funds through interest payments.
APYs vs APRs
When you are looking over a loan document, you might notice an APR, or annual percentage rate. The APR is the figure that lenders use to quote interest rates for potential borrowers. An APR will give you an annualized picture of your interest rate. As the borrower, you’ll be responsible for paying the APR on the loan.
When you are shopping around for interest-bearing accounts, then you’ll find APY quotes available. An APY, or annual percentage yield, is a representation of the interest you stand to gain on your deposit on a yearly basis.
Both are different ways of portraying an interest rate. But the important difference is that an APR will signify to the borrower what their costs will be for taking on this debt. The APY represents what you stand to gain on your savings in particular accounts.
What loans have interest rates?
In most cases, any loan that you take out will have an interest rate attached. The rare exception to this rule is if a family or friend chooses to loan you funds without any interest. All traditional lending sources will have an interest rate attached.
As you learn more about this, you’ll discover that some loans are more expensive than others. For example, credit cards are notorious for having extremely high rates. But mortgages typically have much lower rates.
What is a simple interest rate?
A simple interest rate is a way that interest can be calculated on the initial principal of a loan over the course of the loan. Not all loans are calculated using the simple interest equation, but it is a good place to start learning. When you are looking at a simple interest rate, the formula is shown below:
Simple Interest = Principal x Interest Rate x Time
We will cover a few examples below to help you get more comfortable using the formula.
Simple interest example
Let’s say you are planning to buy a car using an auto loan. Although you have a down payment on hand, you will have to borrow the majority of the purchase price. With that, you expect to pay interest on the loan. But how much interest will you pay?
The auto loan has a principal amount of $25,000 with a 7% simple interest rate and a loan term of 5 years. At the end of 5 years, you would have paid $8,750 in interest payments. Plus, the initial principal leads to $33,750 in total payments.
What is a compound interest rate?
A compound interest rate has the power to spiral into large proportions quickly. Not only is the interest calculated on the initial principal of the loan, but also the accumulated interest from previous periods. The previous periods of a loan could be measured in days, months, or years and will depend on the specific terms of the loan.
Here’s a look at the formula used to calculate the compound interest:
Compound interest = p x [(1 + interest rate)^n-1]
Compound interest example
Let’s say that you are planning to make a similar auto purchase as in the example above. You plan to take out a loan for $25,000 with 7% interest and a loan term of 5 years. We will assume that the rate is compounding on a monthly basis. At the end of 5 years, you would have paid $4,701.80 in total interest payments. That would lead to a total payment for this purchase of $29,701.80.
Why do interest rates change?
You may notice that rates will change over time. They fluctuate in response to factors in the country’s economy. In the US, the Federal Reserve has the power to affect interest rates. When the Federal Reserve chooses to lower rates due to wide economic factors, lenders will follow that trend. If the Fed chooses to raise federal rates, then other lenders will follow suit.
On a smaller scale, your credit history can have a big impact on the interest rates available to you. When a lender is determining an interest rate for a loan, they will look at your credit history. If you have a low credit score, then you present a higher risk to the lender. With that, you should expect to pay higher interest rates. If you have a higher credit score, then you present a lower risk to the lender. With that, you should expect to receive lower rates.
With that, you can work to lower your interest rates on future loans by working to improve your credit score. A lower rate can save you thousands over the lifetime of a loan.
The bottom line
The important takeaway is that interest rates have a big impact on your loan. You could end up paying thousands in interest over the course of a loan. Although some debt may be worth taking on, it is important to understand the consequences of accruing interest.