When you invest your money or take out a loan, you’re affected by an interest rate. Understanding what an interest rate is and how it works impacts how much money you keep or how much you pay out. To help you navigate the interest rate system, here is a guide to the basics.
What is an interest rate?
On a fundamental level, every interest rate involves a lender temporarily giving money to a recipient. The corresponding interest rate for that transaction is, according to Bankrate, “the proportion of an amount loaned which a lender charges as interest to the borrower, normally expressed as an annual percentage.”
You typically associate interest rates with being on the receiving end of the loan, such as charges for credit cards and mortgages. But you act as a lender when you entrust a lending institution with your money, which is why you receive a small amount of money deposited in your account that accrues from the interest rate it pays you. If you’re paying the interest, you’re being charged an annual percentage rate, widely abbreviated as APR. If you’re receiving payments from interest on a financial account or investment, you’re benefitting from an annual percentage yield, or APY.
Why does an interest rate matter?
That interest rate isn’t just a number — it affects how much you have to pay for a loan or how much you’ll benefit from loaning your money to a specific party. That’s why it’s crucial to know what the interest rate you’re agreeing to is and understand how it will impact your finances. Barbara Friedberg of SmartAsset advises, “Before you commit to borrowing money it’s important to know what your interest rate will be. If you can, it’s best to avoid high rates like the plague.”
Understanding interest rates
There are two primary types of interest rates: simple and compound.
A simple interest rate is a consistent rate applied to the entire amount of the loan over the course of the repayment period. Caroline Banton of Investopedia outlines the formula for calculating as principal multiplied by the interest rate multiplied by time. So, a loan of $300,000 for 20 years at 15 percent would equal $900,000 in interest.
Compound interest, on the other hand, charges interest on the principal during previous periods (usually every year) in addition to the principal itself. Because the interest charged increases every year in the compounding system, the bottom-line interest paid can be much higher by the end of the term.
Interest rates can also fluctuate during the loan term based on variables like the borrower’s repayment timeliness and changes to the prime rate.
What you can do
Interest rates are not identical across the board. They vary based on many factors, including the borrower’s credit history, the economy, the type of loan being made, and how fervently either party wants the transaction to take place.
Thus, being able to identify and act on a good interest rate is crucial to managing your finances. When interest rates are low, that’s a good time to take out a loan. When interest rates are high, try to wait for them to decline again. Look for high-yield interest rates on investment and financial account offers.
Also, determine what’s the best repayment schedule you can afford for your budget to minimize the interest cost. Financial experts at Mozo explain, “On many loans, you’ll have the option to make repayments weekly, fortnightly or monthly. Which one you choose will depend on your budgeting style. More repayments means less interest, because of the effects of compounding, so weekly repayments will save you some money.”
If you need assistance calculating the cost or yield of an interest rate to decide when to act and when to pass, talk with your financial advisor.
