What Do Interest Rates Really Mean?
Reading time: 4 minutes
- Even a small percentage difference can impact the amount of interest you pay on a loan
- Credit scores and other factors can play a significant role in credit approval and interest rates
- A lower interest rate will cost you less over the life of a loan
Interest rates will inevitably be a large part of your financial life, but they can be a little confusing. Let’s start with the basics when it comes to interest rates.
What is an interest rate?
To put it simply, interest is the price you pay to borrow money – whether that’s a student loan, a mortgage or a credit card. When you borrow money, you generally must pay back the original amount you borrowed, plus a certain percentage of the loan amount as interest. There are some exceptions: if you pay your credit card balance in full every month, or you have a promotional 0 percent interest rate, for instance, you will not pay interest.
If potential lenders and creditors see a past record of responsible credit behavior and consider you a low-risk borrower, you may receive more favorable interest rates.
The total amount you pay back in interest can vary, depending on the length of your loan and whether interest rates are fixed or subject to change (known as variable interest rates). A fixed interest rate does not change; a variable interest rate is tied to a benchmark interest rate called an index. When the index changes, the interest rate may change as well.
When interest rates are high, it’s more expensive to borrow money; when interest rates are low, it’s less expensive to borrow money. Before you agree to a loan, it’s important to make sure you completely understand how the interest rate will affect the total amount you owe.
Why do interest rates matter?
With a higher interest rate, you may wind up paying more in interest payments over the life of the loan.
An example: You borrow $15,000 for a vehicle loan at 5 percent fixed interest for 48 months. That means you'll pay a total in $1,581 in interest over the life of the loan. If you borrow the same amount for the same time period with 6 percent fixed interest, you'll pay a total of $1,909 in interest, or $328 more. Borrowing the same amount for the same time with 7 percent fixed interest means you'll pay a total of $2,241 in interest -- or $660 more than you would at 5 percent. That's not including any fees associated with the loan.
Another example: You borrow $200,000 for a mortgage at 3 percent fixed interest for 15 years. You’ll wind up paying $248,609.39 over the life of the loan. If your mortgage interest rate is 5 percent, you’ll pay $284,685.71. Those two percentage points mean a difference of more than $36,000.
And let’s talk about credit cards. If you have a $3,000 balance at 15 percent interest and take two years to pay it off with payments of $145.46 per month, you'll pay $491.04 in interest.
In addition, if you don’t pay your credit card balance in full each month, interest will accrue on top of the amount you’ve charged to the card, increasing your debt. That may affect your debt to credit utilization ratio – the amount of available credit you’re using compared to the total amount available to you. And that, in turn, may also negatively impact credit scores.
How is my interest rate determined?
Lenders and creditors have their own criteria to decide what interest rates to offer you. These may include credit scores, credit reports, factors such as your income and the length of the loan. Economic trends, such as the benchmark interest rates mentioned above, also can influence your interest rate, particularly on home mortgages.
Interest rates are generally unavoidable when borrowing money, but it’s worth it to comparison shop and understand the real costs of the loans or credit before you accept.
What is an APR?
An Annual Percentage Rate (APR) is another rate that you may come across when borrowing money. An APR is your interest rate for an entire year, rather than just a monthly fee or rate, on your credit cards or loans, plus any costs or fees associated with the loan. It's the total cost of having the credit card or loan, stated as a percentage. The APR is intended to make it easier to compare lenders and loan options. Credit card companies are required to disclose the APR before issuing the card and also on monthly statements.