What Does That Interest Rate Really Mean?

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, and 13% on your credit cards. Meanwhile, your savings account is earning a paltry 0.5% in interest.

On top of that, there’s the Federal Reserve, which sets interest rates—but which ones? What does it mean when the Fed lowers or raises rates, as did just this month, June 2018?

What’s going on? Why are all of these interest rates so different and what do they mean? Read on!

  1. Mortgages

Buying a home is the largest purchase most consumers will ever make. Mortgage lenders charge interest on the amount they lend to home buyers, and that interest rate will vary based on the buyer’s creditworthiness, and the overall economic trends in the country.

In 2017, the average mortgage rate for a 30-year fixed rate loan was 4.1%. Over the last 40 years, that average rate peaked at 16.64% in 1981, and was as low as 3.65% in 2016. So you can see we are at the low end of the historical average for this rate type. Learn more about these historical rates from Freddie Mac.

Bear in mind that the mortgage’s interest rate is not the same as its APR (Annual Performance Rate). The APR factors in other fees and costs, giving you the total cost of the mortgage, vs. just the interest rate on the loan. The APR will typically by .1 to .5% higher than the interest rate. When comparing mortgages, it doesn’t matter whether you look at the interest rate or APR, as long as you’re looking at the same figure for every loan. If the APR is higher then there are more fees, which should be considered.

If you want to find the best loan, take a look at each lender’s quote carefully. Look at the rate and closing costs, not just the APR, and compare which costs are excluded, and make a side-by-side comparison. Let your lender know you are doing some comparison shopping, ask each of them “how is your loan better than the other lender’s loan?” Show them the loan estimate or good faith estimate and ask them to help you understand.

  1. Credit card

Relative to mortgage and auto loan rates, which are traditionally closer in rates and over the past year been in the 4 to 5% range, a good credit card interest rate can be in the 14-24% in interest.

Why are credit card rates so much higher? In short, they are one of the riskiest loans lenders and banks make. With credit cards, the bank has no physical recourse or collateral to collect the money you’ve borrowed in the event you stop making payments and default on the repayment. They can pursue debt collection efforts, but unlike a car payment where the car can be repossessed for non-payment, there is nothing to take back on a credit card loan. The higher the risk of the loan, the higher the interest rate which helps the lender offset overall losses.

Considering the type of things you use credit cards for, while the rates are a higher, the overall amount of interest, as compared to a mortgage loan for example, should be far less. Credit card balances are limited, and if you handle them correctly, you can avoid paying much interest at all.

  1. Auto loans

Auto loan interest rates tend to be closer to mortgage rates. Right now, an average new auto loan’s APR is 4.74%.  Auto loans are the least risky in many ways since the lender can repossess the car much more easily than a bank can foreclose on a mortgage. Most lenders will require the borrower to have auto insurance to protect the collateral while the loan is being repaid, but otherwise, auto loans carry lower rates than credit cards and a much easier application process than mortgages.

  1. Payday loans

Occasionally you may see stories about payday loans carrying 400% interest. This math comes from the small size of the loan vs. the relatively large finance charge. A payday loan might be as low as $100, and repayment is due in 2 weeks. If this loan carries a $15 fee, then that’s the equivalent of nearly 400% APR.

But it’s not interest paid over time like with credit cards or mortgages. You pay $15. That may not seem like much, but compared to the $100 you borrowed, it’s high.

But paying $15 against a $100 loan isn’t 400%, it’s 15%, right? That’s about what credit cards charge, so why is the APR so different? The Consumer Federation of America teaches us how to calculate the APR for a Payday loan.

The APR is the annual percentage rate, so you take the 15% and multiply it by 365 to get to a full year. 365 x .15=54.75. Divide the answer by the length of the loan (2 weeks=14 days). 54.75/14=3.910. Then you 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%.

  1. Federal reserve rates

The Federal Reserve Bank sets what is called the “federal funds rate”. This is the rate banks charge each other when lending money back and forth. These loans are quick, overnight loans banks take from other banks in order 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 customers for loan products, and what they pay their account holders in interest.

Generally, the Federal Reserve will raise interest rates in good economic times, and lower them when the country is facing recessions and the like. Low rates incentive people to spend rather than save, so the thinking goes that the extra spending will spur a weak economy. When times are good, rates tend to go up, slowing down consumer spending, which helps control inflation.

The Federal Reserve rate affects most of the interest rates set on loans such as auto and credit cards. If the Fed raises rates, auto lenders will raise their rates to match. Many credit cards are pegged to the lender’s “Prime” rate, which is usually tied to the federal funds rate. The rates you earn for CDs or savings accounts will go up or down as the Fed raises and lowers rates.

The one interest rate that isn’t affected that much by the Fed is your mortgage rate. Mortgage rates are affected by the investors who buy bonds and mortgage-backed securities. Sometimes a Fed rate hike will have a small impact on mortgage rates, but experts generally look at other factors when considering what drives mortgage rates.

  1. Savings

These days, the best savings account rate you’ll get is 1.65% annually. That means the bank pays you approximately .1375 a month in interest for saving your money with them. There will be limits placed on how you use the account, like minimum balances. Savings accounts with fewer limitations might pay lower interest; rates as low as .03% are typical.

1.65% isn’t a lot of money, but it will steadily grow your savings for you without any effort on your part. A pretty good deal, right? Unfortunately, it’s not.

Last year, the inflation rate in the US was 2.14%. So the money in your savings account is worth 2.14% less than it was a year ago. If you only earned 1.65%, then your money actually lost value.

This is why it’s best to keep a modest amount in savings, like a 3-6 month emergency fund. Anything extra should be put into a savings vehicle that will earn you more. The very best rates for 5-year CDs are nearly 3%, just beating inflation. Better still are long-term retirement accounts, which can have decades to accrue compound interest before you need to access the funds.

Another option that might make more financial sense is to pay down debts with extra funds. If you’re paying 15% toward credit card debt, you’ll save more by paying it off rather than keeping that same money in a savings account earning less than 2%.

Sources:

https://credit.org/calculators/

https://www.nerdwallet.com/blog/average-credit-card-debt-household/

https://www.bankrate.com

https://www.federalreserve.gov/econres/scfindex.htm?elqCampaignId=5888

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Melinda Opperman

About The Author

Melinda Opperman is an exceptional educator who lives and breathes the creation and implementation of innovate 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.