How Do Interest Rates Work?

If you’re taking the time to teach yourself about finances, you’ve probably heard a little about interest rates. You might also know that taking on high-interest debt is generally not desirable, but if you find a savings account with a high interest rate, that’s a good thing.

But how do interest rates work? We’ll take a closer look.

How do interest rates work?

Interest rates are important in two different situations: when you borrow money and when you save money in an account. 

For example, if you take out a personal loan, you must repay the loan plus interest. The interest rate will be a percentage of the total loan amount.

If you put your money in a savings account, certificate of deposit (CD), or other kind of savings vehicle, you earn interest for doing so. That’s because you’re effectively lending money to the bank. 

Many different factors can influence interest rates, but a major one is the federal funds rate. This is the amount of interest banks charge when they lend money to one another. The federal funds rate is set by the Federal Reserve, which is the central bank of the United States.

What are interest rates?

Depending on the money you’re borrowing or the investment you’re putting money into, you might encounter either simple or compound interest.

• Simple interest is calculated based on the original amount of the loan or investment, so it’s the same each period
• Compound interest is when the interest generated in one period is added to the principal

Compound interest is one reason that high-interest debt like credit cards can grow so quickly. Because the interest from each period is added to your balance, you can end up paying interest on interest.

With a higher interest rate, you’ll pay more for borrowing money. Conversely, you’ll earn more money from an investment with a high interest rate. 

If you borrow money at a lower interest rate, you pay less. However, an investment with a low interest rate will not return much money.

Depending on the lender and the specific financial product, interest rates may also be fixed or variable:

• Fixed interest rates stay the same throughout your loan term
• Variable interest rates fluctuate along with the federal funds rate

With a fixed-rate loan, you’ll lock in the interest rate in advance. Even if the market changes and interest rates fall, the interest rate on your loan remains the same.

If you have a variable-rate loan, your rate may drop later on. However, variable-rate loans are a gamble. If the market changes and interest rates rise, you might be stuck with a higher rate for a while.

How interest rates are determined

The federal funds rate sets a general baseline for interest rates. However, for a financial institution, lending money to a consumer is riskier than lending to another bank. To help offset that risk, financial institutions generally set interest rates on a case-by-case basis.

If you’re applying for a credit card or loan, lenders may look at the following factors when determining your interest rates.

Your credit score

Your credit score is one of the most important factors in the interest rate you can get on a loan:

• If you have a higher credit score, lenders see you as less risky to lend to and usually offer lower interest rates
• If you have a lower score, you pose more risk to lenders, so you’ll likely have a higher interest rate

Before you apply for a loan, check your credit report and look for any errors. If you see a fraudulent account or anything else you didn’t authorize, dispute it with the three major credit bureaus as soon as possible.

Are you planning to apply for a mortgage or car loan in the future? Putting in the work to increase your credit score now can make a major difference in your interest rate. When you sign up with Kikoff, you can start building a positive payment history and strengthening your credit.

The length of the loan term

Shorter loan terms tend to be statistically less risky for lenders, so they usually come with lower interest rates. Unfortunately, there is a downside: shorter loan terms also come with higher monthly payments.

Whether the debt is secured

A secured loan will have some kind of collateral (like a car or a home) that a lender can take if you fail to pay back your debt. Because of the collateral, interest rates for secured loans tend to be lower than rates for unsecured debt.

Your debt-to-income ratio

If you have a significant amount of debt in relation to your income, lenders may be concerned about whether you’ll be able to repay a loan. Since borrowers with high debt-to-income ratios pose a greater risk, they often have higher interest rates.

Difference between APR and interest rate

Many people use the terms “interest rate” and “APR” interchangeably, especially when they’re talking about credit cards and loans. These two terms are related, but they aren’t the same:

• Interest Rate: The cost of borrowing money that you pay to the lender
• Annual Percentage Rate (APR): The cost of borrowing money, plus any additional fees charged by the lender

Both are expressed as a percentage of the principal (the amount you’re borrowing). Because the APR includes additional fees charged by the lender, this number gives you a more accurate picture of the true cost of borrowing money.

How interest rates affect your investments

The relationship between interest rates and your personal finances can be surprisingly complex. Here’s a general overview of how interest rates may impact several different financial products.

Savings accounts

When interest rates are higher across the board, you will probably earn a higher rate on any funds that you have in savings accounts. This means that your money will grow faster over time.

Bonds

You might be surprised to learn that interest rates and bonds tend to move in opposite directions. When interest rates start to rise, the prices of bonds fall. Most bonds have fixed interest rates, which means that the rate of return remains the same.

Stocks and equity funds

If you’ve invested in stocks and interest rates begin to rise, there’s a good chance that the value of your stocks might decrease. 

When interest rates increase, borrowing money gets more expensive, and both consumers and companies tend to spend less. This reduction in spending can make companies less productive and less profitable. When a company’s productivity decreases, its stock price usually will, too.

How interest rates affect your debt

How do interest rates work when you borrow money? Here’s a quick rundown.

Credit cards

Almost all credit card providers charge variable rates. These rates go up and down when the market changes. However, they remain much higher than the rates for most other kinds of loans.

Home equity lines of credit 

Like credit cards, home equity lines of credit (HELOCs) usually have variable rates. However, these interest rates are much lower than those for credit cards. That’s because a HELOC is secured by your home: If you can’t pay, the lender may take it.

Mortgages and car loans

Mortgages and car loans usually have fixed interest rates. Some mortgages, called adjustable-rate mortgages, will fluctuate along with the market.

Student loans

Federal student loans have fixed interest rates. However, some private lenders offer variable-rate loans to borrowers.

Conclusion

If you’re working on building your credit, you might be concerned about interest rates. After all, if you don’t pay off high-interest debt quickly, it can very easily snowball.

We created Kikoff to help people like you build credit without having to worry about high interest rates or hidden fees. When you’re approved, you gain access to a small credit line you can use to buy items in our store. You pay back those purchases interest-free over time. We report those payments to the credit bureaus to help you build a strong credit history.

If you’re ready to get started, we’d love to help you take your finances to the next level. Create your account with us today!