By Kristina Russo | American Express Credit Intel Freelance Contributor
5 Min Read | September, 22 2020 in Cards
Understanding what interest rate means, and how interest is calculated and charged, can help you better manage your finances.
Interest rates define how much it will cost you to borrow money.
Your credit score is key among the factors that influence the interest rate you can get on various types of loans and credit cards.
It’s very likely that you will take out a loan 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 70% 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). By law, interest rates must be disclosed to consumers at the beginning of any lending relationship.2
Interest rates can be either fixed or variable. 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 – the rate at which banks lend to their best customers – or the federal funds rate – the rate at which banks lend to each other, set by the U.S. Federal Reserve. 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.3 Personal loans, auto loans, and some student loans tend to 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.4
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 based on the prime rate, your creditworthiness, and your payment history. 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 entirely if you pay your full balance each month by the due date.
Your Credit Scores. Lenders use credit scores 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 “What is a Credit Score and How is it Defined?”
Experts suggest regularly monitoring your credit scores. You can do that for free at various websites like Credit Karma and MyCredit Guide, and often through your own bank, credit union, or credit card provider. Some free credit score providers may limit the number of times per year you can get a free score.
The Type of Loan. Lenders charge different interest rates for different types of loans. Loans secured by collateral or another type of guarantee have generally lower interest rates than unsecured loans. Interest rates also are generally lower for loans with smaller principal amounts and shorter duration.5 Credit cards often use different interest rates depending on the type of outstanding balance, like purchases, balance transfers, or cash advances.
In the case of mortgages, your interest rate may also be influenced by the type and location of your property and by how much of a down payment you’re making, since a larger down payment lowers the lender’s risk. The Consumer Financial Protection Bureau provides detailed information on how all these interest rate influences apply to mortgages.6
The Type of Lender. Interest rates also vary by the type of lender making the loan. Today, there is a greater variety in lenders including national, regional, and local banks, credit unions, and online lenders. Experts recommend applying for loans at multiple lenders to comparison-shop for the best interest rates. For example, typical interest rates on unsecured personal loans ranged between 5% and 36% in late 20197 – but could be different today, since they constantly change. For these loans, online lenders often offer lower rates than banks and credit unions, if you have a high credit score.
If you’re like most Americans, you’ll pay interest on one or more loans during your lifetime and at least one credit card account. Understanding interest – how interest rates are defined and calculated – is an important step whenever you’re evaluating borrowing choices.
1 “Percentage of Americans with Credit Cards,” The Nest
2 Truth In Lending Disclosures, U.S. Navy Judge Advocate General’s Corps
6 “Seven Factors that Determine Your Mortgage Interest Rate,” Consumer Financial
7 “Average Personal Loan Interest Rates for 2019,” ValuePenguin