Interest Rates and How They Work
What’s an interest rate? How does interest work? What different types of loan interest are there – and how can you know if you’re getting a good rate? Whether you’re applying for a credit card, or a personal, home or auto loan, all are smart questions for borrowers to ask.
This article will answer all your questions, plus we’ll take a closer look at how to get the best rate possible for your loan.
Interest Rates and How They Work
An interest rate is the percentage of the principal (total amount of money borrowed) that lenders will charge you to borrow money from them. This rate can show up as variable or fixed, and represents the cost of borrowing any given sum from a financial institution.
Depending on different factors such as your credit score, borrowing history and type of loan, you’ll have a higher or lower interest rate. The higher the interest rate that you’re assigned, the more you’ll pay in interest each month.
According to the Consumer Financial Protection Bureau, there are seven different factors that go into calculating your interest rate on a loan:
- Your credit score
- The state you live in
- Your loan amount
- Down payment (for mortgages only)
- Loan terms
- Fixed versus variable interest rates
- Loan Type
Lenders typically offer lower interest rates to borrowers that they perceive as being lower risks due to good credit scores, strong borrowing histories, and other factors. Likewise, lenders often assign higher interest rates to those borrowers whom they perceive as higher-risk investments.
While market fluctuations, government policy and other external factors can influence interest rates, high demand for borrowers and high competition among lenders often means that lenders in similar markets offer comparable rates.
Note: As you’re shopping for a loan, you may also come across the term “annual percentage rate” or “APR” which is typically higher than your interest rate figure, as well. That’s because APR offers a more comprehensive look at the total cost of borrowing money over the life of the loan, one-time fees, origination charges and other costs typically imposed by lenders.
When borrowing money, monthly payments that you’ll make include sums that go towards paying off interest rates as well as towards paying off a portion of the principal – i.e. the remaining balance of money that you owe the lender.
As a general rule, though, the higher that inflation rates go, the more likely that interest rates are to rise. That’s because, under these scenarios, lenders request higher interest rates as compensation for the decrease in purchasing power they’ll receive from money paid at a future date.
Why Do You Pay Interest on Loans?
Borrowers pay interest to lenders to compensate them for the use of borrowed funds, and as a safeguard against the borrower defaulting on the loan. In effect, you’re paying to get access to money that you haven’t yet saved up yourself – money that a lender must temporarily part with that they can’t use to power their own investments.
Likewise, you’re also paying a premium for the risk the lender is taking to loan you these sums. Interest is one of the most common ways lenders hedge against risk and earn a profit.
Fixed Vs. Adjustable: What Types of Interest Rate Are There?
Two main types of interest rates exist: fixed and variable (also known as adjustable rates). Specific lenders, especially mortgage lenders, will often give you the option to choose between a fixed or variable interest rate loan option.
Both forms of loans should be carefully weighed given your individual household needs. Below, you’ll find an overview of fixed and variable interest rates, how these types of interest work, and pros and cons associated with both.
How Fixed Interest Works
Fixed interest rate loans lock in an interest rate that remains the same over the entire life of the loan. Because your interest rate won’t change, you’ll know exactly how much you’re paying each month.
If you prefer consistency, fixed interest rate loans may feel right for you. However, because they’re less risky, they often come with slightly higher price tags than variable interest rate loans.
How Variable Interest Works
Variable interest rates fluctuate with the market, and can potentially change from month to month. As market interest rates go up and down, so too can the interest rate on your loan.
Borrowers with good credit may qualify for variable interest rates that come at lower cost than fixed interest rate loans. There’s always the possibility that they may go up, though. However, many variable interest rates come with an interest rate cap, which prohibits them from exceeding certain limits.
Getting the Best Interest Rate
What is a good interest rate – and how can you make sure that you’re getting the best deal for your dollar? If you plan on taking out an auto, personal, or home loan, it pays to know, as a lower interest rate can literally save you hundreds or even thousands of dollars over time, and put money back in your pocket each month.
Below, you’ll find four types of loans that you may commonly consider, and how to know if you’re getting a good interest rate.
At the time of this writing, the average APR for a credit card is 17.31%. However, if you plan to carry a balance, consider calling your credit card provider to negotiate how much interest gets charged. In today’s highly competitive market, many are open to discuss the topic (especially if you have good credit), and even a small reduction in rate could save you hundreds of dollars in interest charges each month.
Pro tip: If you have a strong credit history, also consider signing up for one of several credit cards that offer 0% introductory APR terms. These promotional offers often last 12 to 18 months, and can help you finance large purchases if you need room to pay them off over time without temporarily accruing interest charges.
Should you need access to a large sum of cash, personal loans offer a ready alternative to credit cards. Depending on your individual credit score and borrowing history, current interest rates associated with them hover between 6% and 36%.
At Rocket Loans, you’ll see fixed interest rate plans, meaning you’ll know exactly what your monthly payment is, and never be hit with interest rate changes during the life of your loan.
If you choose to go with a debt consolidation loan, which lets you bundle existing loans into a single monthly payment, also make sure that your offered interest rate is lower than that on the debt you plan to consolidate.
When you take out a mortgage, you’ll apply for either a fixed or variable interest rate. The interest rate will also vary depending on what state you live in, your credit history and whether you have a 15-year or 30-year mortgage.
But in general, the average interest rate for a mortgage ranges between 3.00% to 7.84%. This mortgage calculator can help you figure out your monthly mortgage payments and what kind of interest rate you can expect to receive.
Taking out an auto loan for the purchase of a new or used car is simpler than ever. Your exact auto loan interest rate will depend on your credit history, repayment terms and lender. If you have a high credit score, you can expect to qualify for rates as low as 3%. However, if your credit score is below 580, you’ll be considered a subprime borrower, and your interest rate could be 5 to 6 times higher.
What Interest Rates Mean For You
What is an interest rate? Ultimately, it refers to how much money you’ll pay a lender for loaning you various sums. These expenses show up as an annual percentage that your lender charges on the principal of the loan.
Many factors determine what kind of interest rate you receive, including the type of loan, term length, and your credit score.
However, armed with an interest rate figure, you can quickly calculate your monthly payments and decide how large of a loan that you can afford.
Put simply: The lower your interest rate, the less you’ll pay both monthly and over the lifetime of the loan.
If you want to improve your odds of getting the best interest rate, the best place to start is to work on improving your credit score. This step-by-step guide can help you discover several ways to boost it in minutes.
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