What are Interest Rates & How Does Interest Work?

Interest is the price you pay to borrow money. When a lender provides a loan, they make a profit off of the interest paid on top of the original loan amount.

Interest rates affect the true amount you pay for homes, cars and other purchases made with credit. How an interest rate is determined depends on the type of loan. Use this infographic as a guide to how each type of interest rate works.

What are interest rates

Interest rates play a central role in our financial lives, but sometimes it’s confusing to sort them all out. You might pay 3.5% interest on your auto loan, 4.5% on a home loan, 13% on your credit cards but only earn 0.5% in your savings.

What’s going on? Why are all of these interest rates so different?

In order to truly take control of your finances, you must first understand what an interest rate means, who sets interest rates and the effect interest rates have on your everyday budget. Check out these examples to learn exactly how interest rates work.

How Does Interest Work?

Interest effects the overall price you pay after your loan is completely paid off. For example, if you borrow $100 with a 5% interest rate, you will pay $105 dollars back to the lender you borrowed from. The lender will make $5 in profit.

There are several types of interest you may encounter throughout your life. Every loan has its own interest rate that will determine the true amount you owe.  Before you borrow, make sure you understand exactly how an interest rate will affect how much you owe at the end of the day.

What is Considered a High Interest Rate?

Every loan type has its own average amount of interest. The rate is calculated based on a number of factors, including:

  • The principal amount
  • The length of the loan term
  • The repayment schedule
  • Monthly payment amount
  • Market factors
  • The borrower’s credit-worthiness

Because no two loans are alike, it can be hard to determine what a good interest rate is. Your credit cards, auto loans, personal loans and mortgages all have unique factors that are used to determine your interest rate.

What is an APR?

An Annual Performance Rate, or APR, is another rate you may encounter when taking out a personal loan, mortgage loan, auto loan or credit card. This rate is the amount of interest you will pay over the course of a year, including any extra fees your loan process may incur.

The APR will typically be .1 to .5% higher than the interest rate. If the APR is higher, expect to have more fees.

Many borrowers compare APRs when deciding between different loan options. These rates are valuable negotiating tools – it is not uncommon to reference the rate of a competing lender in order to secure the best rate available.

Types of Loans and Interest Rates

How Does Mortgage Interest Work?

Taking out a mortgage loan is the largest loan most consumers will ever have, so it’s important to consider all the aspects of buying a home. The interest that mortgage lenders charge on the amount they lend to home buyers is based on the buyer’s credit and the overall economic trends in the country.

Over the past 40 years, the average mortgage rate, or interest rate on a mortgage loan has fluctuated between 3.56% and 16.64%. While purchasing a home is a great example of a financial goal, before you take out a mortgage loan, it’s important to do your research to determine if now is the time to buy. 

If you want to find the best loan, take a look at each lender’s quote carefully. Be sure to consider:

  • Interest rates
  • Closing costs
  • Administration fees
  • Brokerage fees

Some of these costs may be included in the APR. Make sure that you inquire about what is covered before making a side-by-side comparison.

As of 2019, the average mortgage loan interest rate is around 4-5%.

How Does Credit Card Interest Work?

Unlike auto and home loans, banks and lenders have no collateral to collect in the event that a borrower defaults or stops making payments on their credit card. As a result, credit cards will have a higher interest rate than other loan types to offset overall losses. The average credit card interest rate is in the 14-24% range.

Credit card balances are limited. If you handle them correctly, you can avoid paying significant amounts of interest. Credit cards are a great tool if you know how to manage them, but you don’t want to end up with too many credit cards that you can’t manage the balances. 

How Does Interest Work on a Car Loan?

When you apply for a car loan, the car is used as collateral. Most lenders will require you to have auto insurance to protect the collateral while the loan is being repaid. If you miss any payments, the bank can repossess the car to cover the costs of the loan.

Because the process of repossessing a car is fairly straightforward and doesn’t cost the lender very much in fees, borrowers can expect lower interest rates on car loans. Auto loans typically have interest rates in the 4-5% range.

How Does Interest on Payday Loans Work?

You may have heard about payday loans and their unreasonably high interest rates. But how can these loans have rates that are so high?

A payday loan is a small, short-term loan used when money is needed immediately. Borrowers are expected to repay the loan when they receive their next paycheck. To encourage quick repayments, lenders will often use extremely high interest rates as service fees.

For example, a payday loan might be as low as $100 with repayment due in 2 weeks. If this loan carries a $15 fee, then the APR will be around 400%.

Unlike credit cards and mortgages, this fee is not repaid over the course of a year. Although $15 may not seem like much, it is a high interest rate compared to the $100 you initially borrowed.

How does $115 result in an approximate 400% APR rate?

$15 is 15% of the $100 borrowed. The APR is the annual percentage rate, so 15% must be multiplied by the number of days in a year:

.15(365) = 54.75

Divide the answer by the length of the loan (2 weeks=14 days).

54.75/14=3.910.

Move the decimal point to the right two places to get your APR. So a $15 charge for a 2-week loan of $100 means the APR is 391%.

What are Federal Reserve Interest Rates?

The Federal Reserve Bank, or Fed, is the central bank in the United States. This bank sets what is called the “federal funds rate,” a rate one bank will charge another bank for quick, overnight loans needed to meet their legal reserve mandates.

The Fed also sets the “federal discount rate,” which is interest the Fed charges banks when they borrow from the Federal Reserve itself.

These Federal Reserve rates impact the rates that banks charge for loan products.

Generally, the Federal Reserve will raise interest rates in good economic times, and lower them when the country is facing recessions. Low rates encourage consumers to spend rather than save, thereby re-boosting a receding economy. The rates are meant to help control inflation.

Lenders will raise and lower their rates to match the Federal Reserve. An example of loans that will be affected by Federal Reserve rates include:

  • Auto loans
  • Credit cards
  • Savings accounts
  • Certificates of Deposits (CDs)

One interest rate that isn’t directly affected by the Fed is your mortgage rate. Mortgage rates are affected by investors who buy bonds and mortgage-backed securities. Although a federal hike may have a small impact on mortgage rates, experts generally look to other factors.

How Does Savings Account Interest Work?

Typically, savings accounts are viewed as opposites of a loan rather than borrowing money, you are providing money to the bank to loan to other people. As an incentive for keeping your savings with a bank, you will often be provided interest on your savings.

Because the bank will be paying you rather than making money from your interest, the rates will be drastically smaller. The average annual interest rate is around the 1-2% range.

Savings accounts also come with several stipulations. You may have limits on how you use the account, like minimum balances. Accounts with fewer limitations might pay lower interest rates.

Saving accounts are best for emergency funds. To make more on your savings, consider investing in a savings vehicle that will earn you more. Other savings accounts that will increase your rate of return include:

  • CDs
  • Retirement funds
  • Money market funds
  • Bonds

Have More Questions About Interest Rates?

Interest doesn’t have to be a threat. If you have questions about paying interest, taking out loans or any other personal finance topics, reach out to our credit coaches today.

Speak to our certified Debt Coaches to review all of your options and discuss best strategies for getting out of debt.Speak to our certified Debt Coaches to review all of your options and discuss best strategies for getting out of debt.
Melinda Opperman

About The Author

Melinda Opperman is an exceptional educator who lives and breathes the creation and implementation of innovative ways to motivate and educate community members and students about financial literacy. Melinda joined credit.org in 2003 and has over 19 years experience in the industry.