What Exactly are Interest Rates?
If you’ve ever applied for a car loan or credit card, you’ve undoubtedly heard the term “interest rate” thrown around. But if you’re new to lending, you might wonder, what is an interest rate? And what is a negative interest rate or positive interest rate on a loan?
This article will explain what an interest rate is, along with their different types. We’ll also explain how you can know if you’re getting a good interest rate on a loan.
What is an Interest Rate?
An interest rate (or APR) is an additional percentage lenders charge for allowing you to borrow money. You’ll pay this interest every month, as well as a portion of the principle, which is the amount of money you owe a lender. Together, the interest and principle make up your loan payment.
Depending on several factors, like the type of loan, you’ll have a higher or lower interest rate. The higher the interest rate, the more you’ll pay in interest each month.
According to the Consumer Financial Protection Bureau, there are six 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
Fixed Vs. Adjustable-Rate
Now that you understand what an interest rate is, you need to familiarize yourself with the two main types. In some cases, specifically with mortgages, many lenders will give you the option to choose between a fixed or variable interest rate.
Variable rate loans are also sometimes referred to as adjustable rate loans. Here is an overview of fixed and variable interest rates, along with the pros and cons of both.
Fixed Interest Rate Definition
When you take out a loan with a fixed interest rate, your rate will stay the same over the life of the loan. Your interest rate won’t change, so you’ll know exactly how much your loan payments will be every month.
If you’re looking for consistency, then a fixed interest rate may be the best choice for you, as it remains the same throughout the life of the loan. The only downside is that fixed interest rates tend to be slightly higher than variable rates because they are less risky.
Variable Interest Rate Definition
Variable interest rates are determined by the London Interbank Offered Rate or the Prime Rate. Lenders use these two benchmarks to determine the interest rate, then add a margin on top. This means your interest rate will fluctuate with the market and could change from month to month.
If you have excellent credit, you could qualify for a very low variable interest rate. However, there is no guarantee your interest rate will stay that low. But most variable interest rates do come with an interest rate cap, so you’ll know your rate won’t go beyond a certain ceiling.
What is a Good Interest Rate?
If you’re interested in taking out a loan to buy a home or vehicle, you need to have a basic understanding of what makes up a good interest rate. Getting a low-interest rate can save you thousands of dollars over the life of the loan.
Here are four types of loans you may end up considering, and how you can know whether you’re getting a good deal on the interest rate.
At the time of this writing, the average interest rate for a credit card is 17.25%. You only need to voice concerns about credit card interest rates if you plan to carry a balance. If you plan to carry a balance from month to month, a 17% interest rate could add up to hundreds of dollars in interest charges.
If you have good to excellent credit, find a credit card that offers a 0% intro APR. These terms will usually last 12 to 18 months, so this can be a good way to fund a large cost without paying a lot of upfront money in interest.
If you need access to a large sum of cash, personal loans are usually a good alternative to credit cards. Depending on your credit score and history, you’ll qualify for an interest rate of 6% to 36%. Some lenders, like us, offer fixed interest rates, meaning that there will be no interest rate change throughout your loan repayment plan. And when weighing options for a debt consolidation personal loan, make sure that your offered interest rate is lower than 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.
Your 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 2% to 3%. However, if your credit score is below 580, you’ll be considered a subprime borrower, and your interest rate could be five to 10 times higher.
Next Steps for Interest Rates
The interest rate is an annual percentage that your lender charges on the principal of the loan. Many factors decide what kind of interest rate you receive, including the type of loan, the term length and your credit score.
If you want to improve your odds of receiving a low-interest rate, the best place to start is to work on improving your credit score. You can check out some additional resources to learn more about how to build and maintain a good credit score.
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