Interest Rates and How They Work

Illustration of a man at the counter of a bank holding a wallet full of money

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 loaned. Since banks borrow money from you (in the form of deposits), they also pay you an interest rate on your money.

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

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

It's critical to know what your interest rate is. It's the only way to know how much your outstanding debt will cost you.

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 such as credit cards. 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.

Banks charge fixed rates or variable rates, largely depending on whether the loan is a mortgage, credit card, or unpaid bill. 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, If you make an extra payment at any time, it all goes toward principal, helping you to pay the debt off sooner.

The actual interest rates are determined by either the 10-year Treasury note or by the Fed funds rate.

Understanding APR

APR stands for annual percentage rate, which is calculated by starting with the interest rate, then adding 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.

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 especially helpful when comparing a loan that only charges an interest rate to one that charges a lower interest rate plus points.

The disadvantage of relying on 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, 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.

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.

How Interest Rates Drive Economic Growth

A country's central bank sets interest rates. The Federal Reserve is the central bank of the United States, and it sets the fed funds rate as the benchmark. This rate is what banks charge each other for overnight loans. The Fed requires most banks to maintain 10% of total deposits in reserve each night, in order to maintain 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 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 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 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.

Article Sources

  1. Federal Reserve Bank of Minneapolis. "How Do Lenders Set Interest Rates on Loans?" Accessed Feb. 18, 2020.

  2. Consumer Financial Protection Bureau. "What Is the Difference Between Fixed- and Variable-Rate Auto Financing?" Accessed Feb. 18, 2020.

  3. Consumer Financial Protection Bureau. "What Is the Difference Between a Mortgage Interest Rate and an APR?" Accessed Feb. 18, 2020.

  4. Federal Reserve Bank of Chicago. "The Federal Funds Rate." Accessed Feb. 18, 2020.

  5. Federal Reserve. "Reserve Requirements." Accessed Feb. 18, 2020.