If you ever borrow money for a car loan or get a credit card, the lender will charge interest. How this works isn’t always obvious, but it’s essentially a fee for borrowing money.
By understanding interest rates, you can plan your debt more effectively and find ways to borrow at a lower cost. Here’s a complete look at how interest rates work and, more importantly, why they matter for your day-to-day life.
Understanding interest rates
Interest rates can sound like a foreign language, but they aren’t as complicated as you might think. Here are the general concepts behind interest rates, paying interest, and the role these play for borrowers and lenders:
Interest is a fee for using borrowed items: When you borrow something, whether it’s cash, a car, a home, or a computer, the lender cannot use the property during that time. You pay the lender interest in return for them letting you use the borrowed items before returning them.
Interest rates are the price of borrowing money: You see interest most commonly with borrowing money. It’s the cost of temporarily spending someone else’s money to make purchases rather than your own money.
An example of when interest rates apply would be on a credit card. When you spend the credit card company’s money, they charge interest until you pay it back.
Interest applies to the amount you borrow: When you borrow money, the amount you owe is called the principal. The lender charges interest against your unpaid principal. If you take out a $100,000 loan, the lender charges interest against the full $100,000.
As you make payments over time, your remaining loan principal eventually becomes $50,000. The lender would only charge interest against what remains, which in this case is $50,000.
Interest rates set the borrower’s cost and the lender’s return: When interest rates are high, you pay more to borrow money. If you take out $100,000 with a 5% interest rate, you owe $5,000 a year in interest. If the interest rate is 10%, you owe $10,000 a year. Borrowers pay more and lenders earn more when rates are high.
Interest rates impact the economy: When interest rates are high, it costs people more to take out loans for cars and homes. It also costs businesses more to borrow money for new projects and to expand. As a result, individuals and companies spend less when rates are high.
On the other hand, when interest rates are low, people may borrow more because the loans cost less.
A borrower’s risk level affects rates: When someone borrows money, there’s the chance they won’t pay it back. Lenders consider how risky a borrower is when they set interest rates.
If you have a high credit score and a proven track record of paying loans back, chances are you will receive lower interest rates. A borrower with more risk, like someone who missed payments on a past loan, would likely be charged higher interest rates.
Different types of interest rates
When you borrow money, you agree with the lender about the interest rate. Different types of interest rates impact how much you end up paying. Here are some common interest rate types and how they work:
Simple interest rate
A simple interest rate only charges interest on your original principal. The lender calculates how much interest you will owe per year at the start of your loan agreement based on how much you borrow. As a result, you can see how much the loan will cost.
For example, say you take out a loan for $100,000 with a 4% simple interest rate that you will repay in three years. You will owe $4,000 per year in interest, adding up to $12,000 over three years. In total, you will need to repay $112,000 for this loan.
Compound interest rate
A compound rate comes into play when the lender charges interest not only on your principal but also on any unpaid interest.
For example, let’s say you borrow $100,000 with a 4% interest rate, but it compounds every year. After one year, you owe $104,000 from the original $100,000 loan principal plus $4,000 in interest. If you don’t make any payments, your principal would become $104,000. In the second year, you would owe 4% of $104,000, which is $4,160 in interest.
The amount you owe increases as you get further into debt from compound interest. That’s why paying off the principal quickly for loans with a compound interest rate should be a priority.
Compound interest and savings accounts
You can make compound interest rates work in your favor. Banks and credit unions offer interest when you keep money with them. If you put money in a deposit account that earns interest, that interest is compounded. This means as you save more, you earn more interest every year.
When you see an ad for a loan or credit card, it should mention an Annual Percentage Rate (APR). The APR shows how much you will pay per year to borrow, including the interest rate and any extra fees from the lender. The government requires lenders to post the APR so you can adequately compare how much you would owe with different loans.
Fixed and variable interest rates
A fixed-rate loan charges the same interest rate the entire time you owe money. Your monthly loan payments will remain the same.
A variable rate loan adjusts the interest rate based on what’s happening in the economy. As a result, your loan payment can go up and down over time.
If you sign up for a variable rate loan, check the loan terms to find out when your payment can change and by how much so you aren’t caught off-guard.
Loan categories and associated interest rates
Now that you understand how interest rate works, let’s look at specific loan categories. Interest rates have major differences depending on the type of loan:
Credit cards: Credit cards are unsecured loans. This means you aren’t putting up any physical asset for collateral when you borrow money. There’s nothing for the lender to take if you don’t pay your credit card bill. As a result, credit cards charge high interest rates. Since 1991, average credit card interest rates have ranged from 12% to 21%.1
Credit cards also compound monthly, meaning they charge interest on your unpaid balance every month. Aim to pay your credit card balance in full monthly if you can.
Personal loans: Personal loans give you cash, which you can spend however you want. Personal loans are also unsecured. As a result, they tend to charge higher interest rates compared to secured loans with collateral. Depending on your credit score, personal loan rates can range from 10% to 32% APR.2
Mortgages: A mortgage is a loan to buy a home. You secure the mortgage with the property, meaning if you stop paying the loan, the lender can foreclose and repossess your house. In exchange, mortgages charge lower interest rates than other types of loans. Over the past 40 years, mortgage rates have ranged from 3.56% to 16.54%.3 That’s quite a fluctuation, which is why it’s common to hear people complain about the housing market.
Car loans: When you borrow money to buy a car, you secure the loan with the vehicle. If you miss payments, the lender can repossess the car. For this reason, car loans generally have lower interest rates than credit cards and personal loans.
Your interest rate depends heavily on your credit score. If you have a good credit score, the interest rate for a car loan could be similar to a mortgage. However, the rate can be much higher if you have poor credit. Lenders also typically charge higher rates when you buy a used vehicle versus a new vehicle. This is because a new car is in better condition, making it easier for the lender to resell in case you don’t pay the loan.
Payday loans: Payday loans are short-term loans that typically last a few weeks. While convenient, payday loans are costly.
For example, let’s say it costs $15 to borrow $100 for a couple of weeks. That might not sound too bad because $15 is just 15% of $100. But when you put that interest rate in annual terms, it’s an APR of 391%! Avoid payday loans as much as possible.
What factors influence your interest rate?
Besides the type of loan, some other factors can influence your interest rate. Knowing these can help you prepare to qualify for the best rate possible.
Your credit score: Your credit score shows how well you’ve managed loans and credit cards. You can qualify for lower interest rates if you maintain a low credit utilization ratio and always make your payments on time.
If you missed payments in the past or already have a lot of debt, you might have a lower credit score and only qualify for higher rates. A lender might also deny lending you money altogether. Before applying for a loan, you can improve your credit history to qualify for better rates.
Your financial position: Lenders consider your income relative to the size of loan payments. If you can safely cover the payments on the new loan plus your other debts, lenders could see you as a safer borrower and could approve you for lower rates.
Market conditions: Market interest rates go up and down based on the economy. When the economy is strong, more people want to borrow, which pushes rates up. When the economy is in a downturn, interest rates tend to be lower. You can track rates to try timing when you borrow, especially for a large loan like a mortgage.
The loan length: If you borrow for a shorter time, you generally receive a lower interest rate. This is because the lender gets their money back more quickly. Your monthly payments would be higher as you pay off the entire debt over fewer years, but you will owe less in total interest.
The lender: Each lender has their own rates and standards for borrowers. If one quotes you higher rates, you could try applying with a different lender to see if it makes a difference.
What is a high interest rate?
What counts as a high interest rate depends on the circumstance and type of loan. A high interest rate for a mortgage might be low for a credit card. It also depends on market conditions. When you apply for a loan or credit card, you can ask the lender for their rate range to see what’s low and high based on their standards.
Ultimately, you must decide how much value you get from the loan versus the cost. For example, if you need a car to drive to work, it might be worth borrowing at a high interest rate, assuming you can manage the payments.
Understand interest rates for better loan terms
Interest rates can significantly affect how much you pay to borrow, especially for longer and larger loans. By understanding loan interest rates, you’ll be able to find better loan terms.
If you feel comfortable with interest rates and want to start building credit, check out our guide on how to build credit from scratch.