What Is an Interest Rate?

It’s very likely that you will need financing at some point during your lifetime. Maybe you’ll purchase a home or car, finance a wedding or home improvement – or maybe you’ll be among the 84% of Americans with a credit card.¹ To be well-informed when doing so, you’re going to need to understand the meaning of “interest rate”: what an interest rate is, how interest is charged, and what factors influence interest rates.

Let’s get started.

Interest is the amount of money lenders charge you to borrow a set amount of money – the loan principal. The interest rate is that interest charge stated as a percentage of the principal, usually on an annual basis. You repay a loan’s principal plus the interest charges.

Interest rates are sometimes called borrowing rates, lending rates, mortgage rates, or lease rates. Credit card companies call it an annual percentage rate (APR). Lenders must disclose interest rates prior to establishing the loan.²

Interest rates can be either fixed or variable. When it comes to credit cards, fixed interest rates mean that the interest rate must remain fixed for at least a year, and you’ll receive advance notice should they change. With variable rates, your rate can change along with indexed interest rates, such as the prime rate. Typically your APR will fluctuate after a change to the prime rate.³

When it comes to loans, fixed interest rates stay the same for the entire loan term, making your interest charges more predictable. Variable interest rates fluctuate during the loan term according to a set schedule, usually monthly, quarterly, or annually. The fluctuations are based on changes in an associated index rate, such as the prime rate.⁴ Variable interest rates and interest charges can change significantly over the life of the loan, so they may end up much higher or lower than you originally expected. 

There are two main methods of using an interest rate to calculate interest charges – simple and compound. They can result in significant differences in interest costs.

The simple interest method multiplies the principal times the interest rate times the number of years the loan will be outstanding. Some personal loans, auto loans, and some student loans may use the simple interest method.

The compound interest method is different because it generates “interest on interest.” With compound interest, you calculate interest on the amount you owe plus any interest that was not paid during the previous payment cycle, aka “compounding period.” Typical compounding periods are monthly, weekly, and daily. Compounding is the most frequent method for calculating interest for mortgages, credit cards, and small business loans.

The difference between simple and compound interest charges increases with larger principal amounts, longer terms, and more frequent compounding periods.

Credit card issuers typically compound interest daily and charge it monthly. For this reason, carrying an outstanding balance on a credit card can become expensive. The APR is usually a variable interest rate which means that it will fluctuate based on prime rate changes. The outstanding principal associated with credit cards is fluid, changing each time you make a purchase, return, or payment. For most credit card holders, you can avoid credit card interest charges for most purchases if you pay your full balance each month by the due date. Keep in mind that for certain types of transactions, however, such as balance transfers and cash advances, you may still need to pay interest.

Your Credit Scores. Lenders consider a number of factors, including your credit score to evaluate your creditworthiness when determining the interest rate they will charge you. Credit scores are a proxy for how financially responsible you are – they assess the likelihood that you will repay a loan. The higher your scores, the lower a lender’s risk in loaning you money, so the lender can afford to offer you a lower interest rate. For more information on credit scores, read “Credit Score vs Credit Report vs Credit Limit.”