Everything You Need To Know About Interest Rates

Interest rates are a natural part of the borrowing and investing processes. You will encounter interest rates whether you are taking out a home loan or putting money in your savings account. You may also encounter discussions about interest rates on a macroeconomic scale, such as bank-to-bank lending and government policies.

Financial literacy can help you make strategic decisions to protect and grow your money, which is why it is important to get your financial information from reputable news sources. Use this guide to learn about interest rates and how they work.

What Is Interest Rate?

The U.S. Securities and Exchange Commission defines interest as “the price paid for borrowing money.” Lenders do not give out money for free. Instead, they charge interest, which is expressed as a percentage.

Interest rates vary depending on the size of the loan, the lender, and the risk of giving money to the borrower. For example, a small loan of $1,000 could have different interest rates depending on who is issuing the money and who is borrowing it.

How Does Interest Work?

Interest rates are based on how much you owe, the rate lenders want to charge, and your lendability. Borrowers with good credit or who are willing to put collateral against the loan might receive lower interest rates, making the loan more affordable.

Interest also varies based on the type of loan you are applying for or where you are depositing your money. Here are a few common types of institutions where you might encounter interest rates.

Savings

Savings accounts allow you to grow your wealth by accruing interest over time. However, not all savings accounts have the same value. As of August 2024, the average savings account offered customers a 0.36% interest rate while some of the best high-yield savings accounts accrued interest at 5% or higher. Learning about interest rates can help you find a savings account that grows your money faster.

Credit Cards

Credit card interest and rates vary significantly. Some companies offer 0% interest cards for the first year as promotions to attract customers. Other companies charge high interest rates to customers who carry a balance each month.

The good news is that you don’t necessarily have to pay interest. If you are careful with your spending and pay off your balance whenever it is due, you can avoid costly interest charges while potentially accruing points, rewards, or cash back.

Car Loans

Car loan rates can be volatile because they are set by private companies rather than government agencies. They can also vary based on whether you are buying a new or used vehicle, the price of the car, your down payment, and your credit score. In 2024, the average auto interest rate was 6.73% for new cars and 11.91% for used cars.

Student Loans

Students can take out federal student loans with rates set by the government or private loans to fund their studies. Some lenders delay the repayment period to allow students to graduate and find work. This ensures they will have the funds to pay the money back. The 2024-2025 interest rates for federal student loans were around 6.53%.

Mortgage

A mortgage is a loan for your house or condo. Because homes are some of the most expensive purchases Americans make, people tend to be sensitive to interest rates. Even small changes in interest can significantly affect loan costs. In August 2024, the rate was 6.73% for a mortgage, but you can see how interest costs have shifted over time.

APR vs. APY

While understanding interest rates is important, there are other numbers to pay attention to when evaluating loans and investments. The annual percentage rate (APR) is the total cost of the loan. It is the interest rate plus any additional fees. For example:

• Loan A offers a 3% interest rate with a total APR of 7%.
• Loan B offers a 5% interest rate with a total APR of 6%.

Even though the interest rate is higher for Loan B, it is still more affordable because the APR is lower.

A similar concept is the annual percentage yield (APY), which is the yearly interest rate your investment earns. For example, if you consider two high-yield savings accounts and one has a 4% APY and the other has a 5% APY, the second option would be more lucrative.

Understanding APR and APY can help you understand financial documents to decide how to use your money.

Who Sets Interest Rates?

Individual lenders can set their own interest rates based on market demand. Some lenders specialize in helping borrowers with poor credit by offering low interest rates while others use predatory lending practices to charge high fees.

However, most lenders follow interest rate recommendations set by the Federal Reserve. Specifically, the Federal Open Markets Committee (FOMC), sets interest rates to keep the economy stable. The Fed wants to maintain stable prices while maximizing employment. To do this, they might raise or lower interest rate recommendations.

Types of Interest

As you shop for loans, you may encounter different types of interest. These interest types will affect how you pay the money back and how costly the loan is.

• Simple: This is a basic form of interest that involves taking a percentage of the principal.
• Compound: This is the method that the majority of lenders use. The interest owed is calculated at regular intervals — daily, weekly, monthly, or annually — depending on the loan terms.

Along with understanding the types of interest, it helps to be familiar with different types of loans. For example, a fixed-rate loan will have the same interest throughout the terms. However, adjustable-rate and balloon loans can increase your loan costs unexpectedly.

How To Calculate Interest

There are plenty of interest calculators online that can help you understand how much you will pay after taking out a loan. However, it is still important to have a basic understanding of how lenders reach your final loan costs. Here are the formulas you need to know:

• Simple: Total amount = principle x (1 + APR x Time);
• Compound: Total amount = principle x (1 + APR/number of times interest is calculated) times calculated x time.

These formulas can be overwhelming at first, but they are easier in practice. The following examples show how simple and compound interest is calculated.

Examples

• Simple interest: If you owe 10% interest on $1,000, then you would owe $100 per year until you paid back the loan. If you paid the loan back in three years, you would owe $1,300.
  • Using the formula: $1,300 = $1,000 (1 + .10 x 3).
• Compound interest: If you owe 5% interest on $1,000 then you owe $1,050 for the first year if the interest is calculated annually.
  • Using the formula: $1,050 = $1,000 x (1 + 0.05/1) 1 x 1.
• Compound interest: In the second year, you would owe $1,102.50 for the same loan if you have not paid back any of the money.
  • Using the formula: $1,102.50 = $1,000 x (1 + 0.05/1) 1 x 2.

These three examples highlight how you can quickly calculate the simple interest of a loan when borrowing from a friend, but compound interest becomes more complex. This process becomes even more complicated when you are tracking interest payments while also paying down your debt.

Interest rates are a common part of borrowing and investing. Knowing how interest rates are calculated and when to look at APR or APY instead can help you make sound financial decisions throughout your life.