- Interest rates are the method that lenders employ to get paid for the use of their money.
- The rates that lenders charge reflect the Federal Funds Rate set by the Federal Reserve.
- Rates are generally based on the creditworthiness of the borrower and the risk tolerance of the lender.
For thousands of years, loans have been a driving force in the world’s economies. People borrow money for big expenses like cars, homes, school expenses, and vacation. And with credit cards, we’re borrowing money for common daily expenses and online shopping. To take advantage of all this, it’s crucial to answer this basic question: What are interest rates?
A lender charges an interest rate to determine how much the borrower pays for the use of the money. When you buy a coat, you pay a flat fee and the merchant never wants to see that coat again. But when you take out a loan, the lender (or money merchant) expects to see that money returned. You must repay the money, plus a percentage (the interest rate) of the amount borrowed.
Lenders take a risk on every loan. They might never see their money again. When the risk is higher, lenders charge a higher interest rate. When borrowers seem creditworthy and have a good history of repaying loans, lenders might charge a lower interest rate.
Using an interest rate also allows a lender to account for the time the money is loaned out. The longer the borrower takes to repay, the more interest is paid.
Banks, credit unions, and private lenders use your interest payments to cover their business costs. That might include checking credit scores and all the paperwork involved in the loan process. And they try to earn a profit.
How are interest rates determined?
You might have wondered, “Why are there so many different interest rates?” Let’s start at the core: with the Federal Reserve, which is the nation’s central bank. The Federal Reserve’s duties include keeping inflation in check and promoting full employment. It also manages the money supply and sets the Federal Funds Rate—the basis for interest rates throughout the economy.
The funds rate determines the interest rate banks charge when they loan money to each other. That’s a regular and essential occurrence, and the funds rate sets a baseline for the cost of borrowing. That rate also factors into the amount of interest paid for any government bond sold. Interest rates affect the stock market too, and a change in the funds rate can send stocks soaring or plunging.
Now, let’s look at factors that are downstream from the central bank.
The prime rate
The prime rate is the rate banks offer to their best customers. Lenders base other loans on the prime rate. For example, you might receive a credit card offer saying: “Your loan’s interest rate is the prime rate, plus 10%.” The prime rate also can serve as the basis for a personal loan or mortgage loan.
Credit card interest rates
Credit card interest usually starts with the prime rate. The card issuer adds more percentage points, based on factors like the borrower’s credit score, income, and amount of debt. Credit cards tend to feature variable interest rates, so when the prime rate changes, the card’s rate may follow.
Home mortgage interest rates tend to fall at the lower end of consumer loans. Mortgages are not as risky as some other loan types. The home is the collateral and there’s often a substantial down payment too. Mortgage lenders often offer fixed rates, but there are variable rates too. These are called “adjustable-rate mortgages.”
Personal loan rates
There are many types of personal loans. Most feature a fixed interest rate, set when the loan is taken out. There is no threat if interest rates rise. And in periods of lowering interest rates, borrowers could consider refinancing the loan to pay interest at a lower rate.
When a consumer deposits funds into a savings account, or certain checking accounts, the bank pays them interest. They are essentially lending money to the bank, which pays them a nominal interest rate. These accounts provide a variety of services, but the interest paid for savings accounts tends to be much less than the rates charged for loans.
How Do Interest Rates Work?
Interest is only one facet of the loan equation, but it affects the others. Let’s look at what makes up a typical loan:
- The loan term. This is the life of the loan (also called the loan period). It’s the length of time that the loan runs: 12 months, 60 months, 15 years, etc. The longer the term runs, the longer there’s a risk of the borrower defaulting on the loan. So shorter loans might feature lower interest rates than longer ones. A 15-year mortgage vs. a 30-year mortgage is an example of this.
- Secured or unsecured. When the lender holds collateral (a house, car, truck, or boat), the loan is “secured.” That makes secured loans less risky and tends to lower the interest rates. If the loan is unsecured, as with most credit cards, the interest charged tends to be higher.
- The principal. This is the amount of the loan or how much has been borrowed.
- Borrower’s current debt. If a loan applicant already has borrowed money, it could affect the chances for approval. Lenders check to see if monthly payments for loans take a large portion of an applicant’s income—the debt-to-income ratio.
- Credit score. A credit score gives lenders a quick and easy way to gauge a consumer’s track record with debt. In general, the better the credit score, the better the interest rate a consumer can obtain.
- Other factors. Many other factors are involved, as well. A lender might consider the length of residence in one place, how long you’ve held your job, whether you own or rent, or how recently you’ve applied for another loan.
APR vs. APY
If you’re shopping for a loan or looking for a savings account, you’ll probably see the terms APR and APY. They look similar, but one is the financial mirror image of the other. APR is the annual percentage rate for borrowed money. It reflects not just the interest rate but any fees that lenders are charging. Thus, it could give a more accurate look at the total cost of a loan.
APY, on the other hand, is the annual percentage yield. You’ll see this in relation to savings or investment accounts. It’s the interest rate that the account pays to a depositor. It may be variable or fixed interest, and it may be compounded interest or simple interest—it depends on the type of investment.
Both APR and APY are important, just at different times. They are flip sides of the same financial coin.