There are three things in life you can never escape: death, taxes, and interest rates. What is interest, you ask? It enters our lives when we borrow or save money.
If you take out a loan to buy a car, you’ll be charged a fee — or simply a percentage of the loan’s total amount. When you open a bank savings or checking account, the bank will pay you interest on your money. It also affects us in other ways that go far beyond bank loans and savings accounts.
So how do interest rates work, exactly? This can vary depending on whether you're saving or borrowing, among other factors.
How Do Interest Rates Work When Borrowing?
Rates work in different ways. Banks charge either fixed or variable rates, depending on the type of loan you take out, such as a mortgage, credit card, or personal loan. Credit cards typically charge the highest interest — double-digit variable rates in most cases.
Meanwhile, mortgages tend to carry the lowest rates, and most are fixed. When I applied for a mortgage, I knew that the rate would be based on several factors, such as my salary, net worth, debt load, credit score and history, and down-payment amount.
The banks charge interest because they're taking a risk by lending us money.
It's money that we haven’t worked for, and the bank wouldn’t lend if it couldn’t make a profit.
How Do Interest Rates Work When Saving?
The money that banks lend to borrowers must come from somewhere — and that means savers. To entice people to save, banks will offer to pay an interest rate on savings deposits. The more money you stash in your savings account, the more you can earn in interest.
Some banks will pay interest on money in checking accounts, as well. Typically, banks offer monthly rates of about one percent — a lowly sum compared to what they charge for credit cards and personal loans.
For savers, the best rates can be found in certificates of deposit (CDs) that lock away your money for a few months or years. The best rates can be found online using a comparison aggregator like Bankrate. For investors, bonds and money-market funds will pay steady interest, too.
Crunching the Numbers
Banks calculate interest in two ways: simple or compound interest. Simple interest is easy to understand. It’s the money you borrow multiplied by the years of the loan and the interest rate.
Compound interest, on the other hand, is calculated monthly on the entire balance of your savings account or bank loan, which includes the previous interest payments on the balance.
For savers, compounding is what it's is all about.
But for borrowers (especially credit card debtors), that compound interest can add up quickly. That’s why high-interest credit card debt is a curse and should be attacked first in any debt-reduction plan.
Fixed vs. Variable Rates
My mortgage is a 30-year fixed loan with a 4.2 percent annual percentage rate (APR). To be clear, that’s not the true interest rate. My actual rate is slightly lower. That 4.2 percent APR reflects the interest combined with banks fees.
Because the mortgage is tied to my house’s value, my APR is low compared to, say, what a credit card company would charge. If I default, the bank takes ownership of my house. Credit cards aren’t tied to any collateral — just your credit score.
My mortgage is locked in, but I can ask the bank to lower — or “refinance” — my APR or change my fixed-rate loan to a lower, variable rate. Most variable mortgages begin as five- or seven-year fixed loans. After that, the APR becomes variable and is subject to the mercy of market forces.
It’s conjoined with the ups and downs of U.S. Treasury bonds (federal government debt). Today, these bonds pay higher interest rates than they used to. This means that folks with variable mortgages will soon see bigger monthly mortgage bills.
Why Is All This Important?
Interest rates can be your friend or your enemy. We all borrow money. Loans (and low interest rates) grease and sustain the world economy. We borrow to grow and achieve our dreams. And that’s manageable for many.
But unfortunately, many of us borrow simply to survive — and that’s where people (and even some governments) get into trouble. If your finances are precarious and you have bad credit, you’ll have to pay higher interest rates when borrowing.
Higher rates mean less money to spend on yourself. Do your homework and shop around so that you can find the lowest loan rates and best savings rates possible.
For reprint and licensing requests for this article, CLICK HERE.