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Understanding Interest Rates

You can expect to see interest rates when you need to engage in a financial transaction. That is because interest rates are a highly important part of the borrowing process. We will explain why that is and what interest rates are in this article.

What Are Interest Rates?

Interest rates are the amount of money that a lender charges a client to borrow money. It is a percentage of the amount of money that the lender lends to the borrower. The lender applies the interest rate every year, so it is called the “annual percentage rate” or APR. Therefore, the lender is the one who receives this interest, and it is the cost that the borrower pays to receive a loan.

Banks also offer interest rates on money that their customers deposit into their accounts. For example, a savings account or a certificate of deposit or CD typically has an interest rate. In this case, the interest is called the “annual percentage yield” or APY, and the customer receives the interest.

Interest Rates Further Explained

An interest rate is what a lender charges a borrower for an asset. Assets that can have interest rates include property, vehicles, consumer goods and cash. Because this is the case, people often call interest rates “the cost of money.” If the interest rate is low, the cost of money is also low, and the borrower does not pay as much interest over the life of the loan. If the interest rate is very high, it means that the borrower pays a high price for borrowing money because the monthly payments will be very high.

In most cases, interest rates apply whenever anyone engages in a financial transaction. People borrow money for all types of purposes, including paying a child’s college tuition, starting a business, funding research projects and buying homes. People can repay their loans in a lump sum, but most make installment payments.

Interest Rates on Loans

The amount of money borrowed determines the interest rate or the lender’s rate of return. While the borrower has the money that the lender lent him, the lender cannot use this money for any other purpose. For this reason, the borrower must compensate the lender for the loss of use of the money, and this compensation is the interest the borrower pays. Therefore, the borrower pays the lender a larger sum of money than he borrowed.

The lender assigns a low interest rate when he or she considers the borrower to be low risk. This means that the borrower is not likely to default on the loan, and the lender determines this risk by examining the borrower’s credit reports. If the lender finds that the borrower has a low credit score because of non-payment of bills, the lender will consider the transaction to be risky. The fact that the borrower has a history of defaulting on debts makes this borrower a likely candidate to default on the current loan. In this case, the lender will set a higher interest rate, so it costs the borrower more to receive the loan.

An Example of a Simple Interest Rate

The bank lends you $300,000. Your lender charges you a 4% simple interest rate. Along with repaying the original $300,000, you must also pay the bank interest. The interest is .04 X $300,000 or $12,000.

To calculate the simple interest rate, you would use the following formula:

Principal of the Loan X The Interest Rate

$300,000 X .04 = $12,000

If the loan’s term listed above is one year, the borrower will pay $12,000 in interest for the year.

What Would the Simple Interest Rate Be for a 30-year Mortgage?

You would use the following equation to figure the payment for a 30-year mortgage:

Principal of the Loan X The Interest Rate X Time

$300,000 X .04 X 30 = $360,000

The annual interest payment would be $12,000. After paying $12,000 for 30 years, the borrower would have paid $360,000.

What Is Compound Interest?

Compound interest would be even more beneficial for a lender. Compound interest is often called “interest on interest” because the lender applies the interest to the principal and the amount of interest that accumulates during different periods. With compound interest, the borrower owes the principal and interest for borrowing money for the first year. In the second year, the borrower owes the principal and the interest for the first year, but he also owes interest on the interest from the first year.

This means that you will pay more in interest when the lender compounds the interest.

What about Compound Interest on Savings Accounts?

As you might have guessed, it would be better for you to save money in a savings account that offers you compound interest. A bank or credit union offers clients compound interest as an incentive for depositing funds in the bank. When clients do this, the bank has funds that it can use for other purposes.

An Example

After you deposit $500,000 into a high-yield savings account, the bank may take $300,000 of this money and offer a mortgage loan to another client. You deserve compensation when the bank does this, so the bank gives you 1% in interest for the year.

The Annual Percentage Rate or APR and the Annual Percentage Yield or APY

When a bank offers someone a loan, they apply the APR to your debt. The APR is what they expect for giving you the ability to use their funds. You may have heard the interest rate on credit cards quoted as an APR. Compound interest is not a factor in the APR.

The bank or a credit union offers you an APY when they offer you savings accounts or certificates of deposit. The APY does include compound interest in the calculations.

How Do They Determine Interest Rates?

In the United States, the Federal Reserve is in charge of setting interest rates. Each lending institution uses these rates to create a range of interest rates that they will offer their clients. If the Federal Reserve decides to increase interest rates, the cost of debt increases. When this occurs, people decide to wait to borrow money, and it slows the economy down.