Interest Rates and How They Work

What Is an Interest Rate?

Illustration of a man at the counter of a bank holding a wallet full of money. Headline is “What to Know About Interest Rates” and text is “An interest rate is the percentage of principal charged by the lender for the use of its money. The interest rate will tell you what you pay each month, as opposed to the APR, which tells you the total cost over the life of the loan”

The Balance / Maddy Price

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 loaned.

Interest rates affect the cost of loans. As a result, they can speed up or slow down the economy. The Federal Reserve manages interest rates to achieve ideal economic growth.

What Is an Interest Rate?

An interest rate is either the cost of borrowing money or the reward for saving it. It is calculated as a percentage of the amount borrowed or saved.

You borrow money from banks when you take out a home mortgage. Other loans can be used for buying a car, an appliance, or paying for education.

Banks borrow money from you in the form of deposits, and interest is what they pay you for the use of the money deposited. They use the money from deposits to fund loans.

Banks charge borrowers a slightly higher interest rate than they pay depositors. The difference is their profit. Since banks compete with each other for both depositors and borrowers, interest rates remain within 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, and you must pay at least the interest in each compounding period. 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 tend to assign a higher interest rate to revolving loans such as credit cards, as these types of loans are more expensive to manage. Banks also charge higher rates to people they consider risky; The higher your credit score, the lower the interest rate you will have to pay.

Fixed Versus Variable Interest Rates

Banks charge fixed rates or variable rates. Fixed rates remain the same throughout the life of the loan. Initially, your payments consist mostly of interest payments. As time goes on, you pay a higher and higher percentage of the debt principal. 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. With either type of loan, you can generally make an extra payment at any time toward the principal, helping you to pay the debt off sooner.

How Are Interest Rates Determined?

Interest rates are determined by either Treasury note yields or the fed funds rate. The Federal Reserve sets the federal funds rate as the benchmark for short-term interest rates. The fed funds rate is what banks charge each other for overnight loans.

The fed funds rate affects the nation's money supply and, thus, the economy's health.

Treasury note yields are determined by the demand for U.S. Treasurys, which are sold at auction. When demand is high, investors pay more for the bonds. As a result, their yields are lower. Low Treasury yields affect interest rates on long-term bonds, such as 15-year and 30-year mortgages.

Impact of High Versus Low-Interest Rates

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, which drives up stock prices. 

Low-interest rates make business loans more affordable. That encourages business expansion and new jobs.

If low-interest rates provide so many benefits, why wouldn't they be kept 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 the demand outstrips supply and prices rise; That's just one of the causes of inflation.

Understanding APR

The annual percentage rate (APR) is the total cost of the loan. It includes interest rates plus other costs. The biggest cost is usually one-time fees, called "points." The bank calculates them as a percentage point of the total loan. The APR also includes other charges such as broker fees and closing costs.

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.

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

The APR calculates the total cost of the loan over its lifespan. Keep in mind that few people will stay in their house with that loan so you also need to know the break-even point, which tells you at what point the costs 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 monthly amount saved in interest.

$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

In the example above, the monthly savings is $39. 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 would be better off taking the higher interest rate. You'd pay less by avoiding the points.

The Bottom Line

  • Interest rates affect how you spend money. When interest rates are high, bank loans cost more. People and businesses 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.
  • Interest rates affect your cost of borrowing money. Always compare interest and APR when considering a loan product.
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Article Sources

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  2. Discover. "How Does Savings Account Interest Work? Here’s Your Guide." Accessed Sept. 11, 2020.

  3. Accounting Tools. "Compounding Period." Accessed Sept. 11, 2020.

  4. Federal Reserve Bank of Minneapolis. "How Do Lenders Set Interest Rates on Loans?" Accessed Sept. 11, 2020.

  5. Consumer Financial Protection Bureau. "What Is the Difference Between a Fixed APR and a Variable APR?" Accessed Sept. 11, 2020.

  6. My Home by Freddie Mac. "Fixed-Rate Mortgages." Accessed Sept. 11, 2020.

  7. Board of Governors of the Federal Reserve. "What Is the Prime Rate, and Does the Federal Reserve Set the Prime Rate?" Accessed Sept. 11, 2020.

  8. Federal Reserve Bank of Chicago. "The Federal Funds Rate." Accessed Sept. 11, 2020.

  9. Federal Reserve Bank of St. Louis. "Fed Policies' Continued Effects on Short-Term Liquidity Markets." Accessed Sept. 11, 2020.

  10. Federal Reserve Bank of San Francisco. "How Does Monetary Policy Affect the U.S. Economy?" Accessed Sept. 11, 2020.

  11. Consumer Financial Protection Bureau. "What Is the Difference Between a Mortgage Interest Rate and an APR?" Accessed Sept. 11, 2020.