Interest Rates and How They Work

Examples of How Interest Rates Work

Image shows a man at the counter of a bank holding a wallet full of money, and he is talking to the bank teller. Text reads:

Image by Maddy Price © The Balance 2019

An interest rate is the percentage of principal charged by the lender for the use of its money. The principal is the amount of money lent. As a result, banks pay you an interest rate on deposits. They are borrowing that money from you.

Anyone can lend money and charge interest, but it's usually banks. They use the deposits from savings or checking accounts to fund loans. They pay interest rates to encourage people to make deposits. 

Banks charge borrowers a little higher interest rate than they pay depositors so they can profit. At the same time, banks compete with each other for both depositors and borrowers. The resulting competition keeps interest rates from all banks in a narrow range of each other.

How Interest Rates Work

The bank applies the interest rate to the total unpaid portion of your loan or credit card balance.

It's critical to know what your interest rate is. It's the only way to know how much it adds to your outstanding debt.

You must pay at least the interest each month. If not, your outstanding debt will increase even though you are making payments.

Although interest rates are very competitive, they aren't the same. A bank will charge higher interest rates if it thinks there's a lower chance the debt will get repaid. For that reason, banks will always assign a higher interest rate to revolving loans, like credit cards. These types of loans are more expensive to manage. Banks also charge higher rates to people they consider risky. It's important to know what your credit score is and how to improve it. The higher your score, the lower the interest rate you will have to pay.

Banks charge fixed rates or variable rates. It depends on whether the loan is a mortgage, credit card, or unpaid bill. The actual interest rates are determined by either the 10-year Treasury note or by the fed funds rate.

Fixed rates remain the same throughout the life of the loan. Your initial payments consist mostly of interest payments. As time goes on, you pay a higher and higher percentage of the debt principal. If you make an extra payment, it all goes toward principal. You can pay the debt off sooner that way. Most conventional mortgages are fixed-rate loans.

Variable rates change with the prime rate. When the rate rises, so will the payment on your loan. With these loans, you must pay attention to the prime rate, which is based on the fed funds rate. If you make extra payments, it will also go toward paying off the principal.

Understand APR

The APR stands for annual percentage rate. It allows you to compare the cost of different borrowing options. The APR starts with the interest rate. It then adds one-time fees, called "points." The bank calculates them as a percentage point of the total loan. The APR also includes any other charges, such as broker fees and closing costs.

APR Versus Interest Rates

Both the interest rate and the APR describe loan costs. The interest rate will tell you what you pay each month. The APR tells you the total cost over the life of the loan.

$200,000, 30-year Fixed Rate Mortgage Comparison
Interest Rate       4.5%          4%
Monthly Payment    $1,013        $974
Points and Fees           $0     $4,000
APR        4.5%        4.4%
Total Cost $364,813 $350,614
Cost After 3 Years   $36,468   $39,064

Use the APR to compare loans. It's really helpful when comparing a loan that only charges an interest rate to one that charges a lower interest rate plus points.

The only disadvantage of the APR is that very few people will stay in their house for the entire life of the loan. So you also need to know the break-even point. It tells you when the cost of two different loans are the same. The easy way to determine the break-even point is to divide the cost of the points by the amount saved in interest.

In the example above, the monthly savings is $39 a month. The points cost $4,000. The break-even point is $4,000 / $39 or 102 months. That's the same as 8.5 years. If you knew you wouldn't stay in the house for 8.5 years, you'd take the higher interest rate. You'd pay less by avoiding the points.

How Interest Rates Drive Economic Growth

A country's central bank sets interest rates. In the United States, the fed funds rate is that guiding rate. It's what banks charge each other for overnight loans. The Federal Reserve is the central bank of the United States. It requires banks to maintain 10 percent of total deposits in reserve each night. Otherwise, they would lend out every single penny they have. That would not allow enough of a buffer for the next day's withdrawals. The fed funds rate affects the nation's money supply and thus the health of the economy.

High-interest rates make loans more expensive. When interest rates are high, fewer people and businesses can afford to borrow. That lowers the amount of credit available to fund purchases, slowing consumer demand. At the same time, it encourages more people to save because they receive more on their savings rate. High-interest rates also reduce the capital available to expand businesses, strangling supply. This reduction in liquidity slows the economy.

Low interest rates have the opposite effect on the economy. Low mortgage rates have the same effect as lower housing prices, stimulating demand for real estate. Savings rates fall. When savers find they get less interest on their deposits, they might decide to spend more. They might also put their money into slightly riskier, but more profitable, investments. That drives up stock prices. Low-interest rates make business loans more affordable. That encourages business expansion and new jobs.

If they provide so many benefits, why wouldn't you just keep rates low all the time? For the most part, the U.S. government and the Federal Reserve prefer low-interest rates. But low-interest rates can cause inflation. If there is too much liquidity, then demand outstrips supply and prices rise. That's just one of the two causes of inflation

The Bottom Line

Interest rates affect how you spend money. When interest rates are high, bank loans cost more. People and business borrow less and save more. Demand falls and companies sell less. The economy shrinks. If it goes too far, it could turn into a recession.

When interest rates fall, the opposite happens. People and companies borrow more, save less, and boost economic growth. But as good as this sounds, low interest rates can create inflation. Too much money chases too few goods.

The Federal Reserve manages inflation and recession by controlling interest rates. So pay attention to the Fed's announcements on falling or rising interest rates. You can reduce your risks when making financial decisions such as taking out a loan, choosing credit cards, and investing in stocks or bonds.