What Is an Interest Rate? And How Do They Work?

Written by Jennifer PachecoUpdated: 21st Nov 2021
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Knowing what an interest rate is and how it works is a key aspect of properly navigating and managing your finances. If you’re looking to learn the basics of an interest rate, you’ve come to the right place.

Simply put, an interest rate greatly affects the total amount of money you pay a financial institution throughout a time period.

If you’re borrowing money for a mortgage, car purchase, or personal reason, the interest rate will tally up how much money you’ll pay to borrow the funds. For example, if you have a 5% interest rate on an auto loan, you’ll pay a 5% interest rate to that bank or credit union to use their money for the loan term.

If you’re borrowing money from a credit card company, the same process applies. The interest rate will apply to whatever money you have used in your credit line that month. If the purchases for that month are not paid up by the time the billing cycle hits, you’ll have to pay the money you owe plus the interest rate for borrowing.

What Is an Interest Rate?

Wouldn’t the world be so much simpler if we could borrow from others without having to pay them any additional money? Unfortunately, that’s not the way the world works. This is why interest rates were created.

An interest rate is basically what the financial institution earns for allowing you access to their money. When applying for a loan, you get the principal amount to pay off the end client (real estate agent, car lot, etc.). But with that comes a price. That’s how financial institutions make their money.

How Do Interest Rates Work?

Interest ultimately affects the overall borrowing amount you have to pay a financial institution back. For example, if you’re purchasing a vehicle for $10,000 and you borrow through a bank that has a 10% interest rate on auto loans, at the end of your term, you’ll end up paying $11,000. In turn, the bank gets $1,000 from you for lending you the money.

Keep in mind that every loan is not the same. Mortgage interest rates will differ from auto loan interest rates. Just like auto interest rates will differ from personal loan interest rates. The interest rate will also vary from institution to institution.

Differences Between Fixed and Variable Interest Rates

The type of interest rate you choose will affect the amount of money you owe the lender.

If you choose to go with a loan and fixed interest rate, you’ll pay the same percentage of interest each month until the loan term is up. For example, if you get a mortgage loan with a 4% interest rate, your monthly payment will always be the principal amount owed with that 4% additional interest charge.

If you choose to go with a loan and variable interest rate, the amount you pay your lender monthly may change. Variable interest rates often give you a range of where the interest can fluctuate between.

For example, if you start a mortgage variable interest rate loan out with 5%, you probably won’t drift too far away from the 3% – 7% range. The variable rate does, however, change according to the market’s needs. If the market is doing well, you’ll likely experience a lower interest rate. If the market is doing bad, you’ll likely experience a higher interest rate.

A financial institution cannot give you an exact answer on how much money you’ll be paying throughout the term with a variable interest rate. You’ll only find out how much interest you’ve paid on this type of loan after your last payment is made.

How Are Interest Rates Determined?

The main determinant of interest rates is how the economy is doing. Banks, credit unions, and all other financial institutions think about various factors before simply slapping a number on what borrowers owe them. Fortunately, and unfortunately, the Federal Reserve (speaking of the United States) determines a roundabout number or suggestion for the rest of the world to implement.

If the Federal Reserve sets the suggested interest rate high, that means most other financial institutions will set their interest rates high. This can indicate a troubling time for the economy, where borrowing from lenders is not encouraged.

>> More: How the Federal Reserve Affects Mortgage Rates

Interest Rates Examples

An example was explained above, but here is another for good measure reference.

If you’re taking out a mortgage for $400,000 on a nice suburban home, you’re going to shop until you find a low and affordable interest rate. Eventually, you come across a local bank that offers a 3% fixed interest rate for all newcomers, so you take the bank up on their offer.

Once all is said and done, you’re responsible for paying that bank their $400,000 plus the 3% interest rate they have applied to the loan. To get the total number, you’ll want to multiply 3% by $400,000, which would equal $12,000. Then, you’ll want to add the $12,000 to the initial principal amount of $400,000, which equals $412,000. That’s the total amount of money you’ll pay the bank back once the loan term is up.

Is Interest Rate a Good or Bad Thing?

To be honest, interest rates are neither good nor bad. They’re necessary if you want to borrow money from a lender – lenders have to make out ok in the end if they’re allowing you to borrow their funds.

The only thing to look out for is the economy’s welfare. If the economy is not doing so hot, your interest rates will likely be higher than the average. If the economy is doing great, you may get away with a “steal” of an interest rate.

Do Interest Rates Affect Loans and Credit Cards?

Interest rates only affect the amount of money you will pay back to the bank, credit union, or credit card company. This is their “charge” for allowing you to have the funds for a mortgage, auto loan, personal loan, etc.

Bottom Line: What Is an Interest Rate?

The bottom line is that every financially responsible adult should know and understand what an interest rate for many reasons. First off, knowing the interest rate will directly go back to how much money you spend on a loan or credit card billing cycle.

Remember that when interest rates are high, the economy is not doing too good, and you might want to hold off on borrowing for the time being. But to be honest, nothing’s better than saving up some money and spending the money once you have it – to not be a part of any interest rate will save you the most! If the economy is doing well, that’s the time to borrow.

Jennifer Pacheco

Jennifer Pacheco attended the University of Dartmouth, Massachusetts where she earned her degree in English Writing & Editorial Work. She is a seasoned personal finance writer with over 5 years of professional work under her belt, and supplies easy-to-read information that’s educational, engaging, and conversational to help you make the most of your money.