Why Interest Rates Matter
Point of Interest
Interest rates can seem like small differences in percentages. But even a tenth of a percent can make a massive difference in how much you earn or pay over time.
Borrowing money from an institution rarely comes freely. If you’re taking out a cash loan to start a business, making purchases with a credit card, or getting a mortgage to buy a house, you’ll typically have to pay interest to the lender for the privilege of borrowing their money.
Interest is generally charged as a percentage of the principal amount. That factors into the annual percentage rate (APR). For example, say you borrow $1,000 each year. If your loan has an APR of 5%, you’d pay $50 a year. The APR covers the entire cost of what you’re borrowing, which may include things like fees and closing costs.
Interest also relates to the amount of money you can earn on a savings account or on investments like stocks and bonds. When your investment stays untouched, but you keep earning interest on your investment over time, that’s compound interest. In this case, you’re making money on both your initial investment and the interest you’ve been earning.
That type of interest earned is called an annual percentage yield (APY). When you’re looking at bank accounts like savings accounts or certificates of deposit, the higher your APY is, the more you can potentially make off your savings.
With just about anything related to your finances, interest rates are important to pay attention to. High ones can negatively impact you or benefit you depending on what they apply to.
Different savings accounts will compound interest at various times — sometimes daily, monthly or quarterly. If you have an account with $5,000 and a 1% APR, you’d make $50 in a year. On the other hand, if you have a savings account with $5,000 and daily compound interest at an APY of 1%, you’d end the year with around $5,050.25.
While that’s a difference of $0.25, over time, you’d make much more. For example, in 10 years with compounding interest, you’d make $5,525.25. You’ve added more than 10% to the value of your investment. If you invest more each month, you can grow your savings for retirement, emergencies or other needs. Because of compounding interest, a small increase or decrease in interest rates can make a big difference over time. That’s one reason to consider savings accounts with online banks compared to traditional banks. Big traditional banks have to pay for overhead like branch buildings. Online banks can pass on the savings from overhead to customers.
Money Money Accounts
Interest rates for money market accounts work similarly. A money market account is a savings account that earns interest. The bank may then loan out that money to other people. The bank charges those they lend money to a higher interest rate than what they’re paying you, so the bank makes money. Interest on money market accounts is typically compounded daily and may be paid monthly. Typically, you can get higher interest rates on a money market account when you put in higher amounts of money.
Certificates of deposit (CDs) also feature interest-earning capabilities. CDs usually have higher interest rates than savings accounts because you’re expected to keep your money in the CD for a fixed period of time. After the fixed term is over, you get your principal plus interest earned back. CDs usually have early withdrawal penalties. You want to make sure you can keep your hands off whatever you put into a CD. Longer terms and higher deposit amounts can typically result in a higher interest rate and APY.
Loan Interest Rates
With loans, typically the higher the risk of the loan, the higher the interest rate will be. A loan that the lender considers low risk will usually have a lower interest rate.
Consumer loans typically use an APR. This means that interest does not compound. The interest rate is a flat rate for the life of the loan. Borrowers pay back interest on the initial loan amount, usually divided by and tacked on to loan payments.
There are several factors that affect how much interest you pay on a loan. These include:
- Principal amount: The amount you’re looking to borrow.
- Loan term: How long you’ll be repaying your loan — longer terms may mean lower payments, but more interest over the life of a loan.
- Repayment schedule: More frequent payments may result in having to pay less interest.
- Repayment amount: Higher repayment amounts could mean less interest if that allows you to pay off your loan more quickly.
When you’re comparing loans, you should take into account the loan term, repayment schedule and repayment amount you’ll be able to pay, in addition to the APR. All these factors can affect the amount of interest you pay, so it’s best to calculate and compare loans.
Credit Card Interest Rates
Taking out money on a credit card is like taking out a loan. You’ll have to pay interest on top of what you borrow if you don’t repay the full amount in time. As you add to your balance, the amount of interest is also going to increase. Delaying paying off what you’ve borrowed can result in credit card debt accumulation. Credit card businesses typically quote an interest rate as an APR. Usually, the APR rate is a variable APR. The percentage may depend on the borrower’s creditworthiness, as a credit score is usually analyzed before approving someone for a line of credit. Credit card interest rates don’t matter much if you use credit cards responsibly and pay off the balance in full when it’s due. Otherwise, higher rates can make credit card debt climb. You may want to wait and increase your credit card score before applying for a new credit card so you can lock in a lower variable APR. With any credit card you get, the APR will typically be much higher than what it’d be with a loan or mortgage.
Over time, you may be able to lower your APR with your credit card provider through responsible use and by increasing your credit score. But that’s rarely guaranteed. It’s best to lock in a low score when you first get approved for a credit card.
Mortgage Interest Rates
A mortgage is a home loan. Most home loans use simple interest, meaning interest is not compounded. Some loans do use compounded interest, which applies to both the principal amount loaned and to the interest that has accumulated over previous periods. A popular form of mortgage is a fixed-rate mortgage. The benefit of a fixed-rate mortgage is that you can lock in a low interest rate. Even if the national rate goes up in the future, you’ll still be able to pay at the low rate you initially received. An adjustable-rate mortgage provides a low initial fixed rate for a certain amount of time (usually five or seven years), often at a lower rate than a fixed-rate mortgage. After the initial time period ends, the rate can raise (or lower) to meet the current market rate. The home loan borrower may benefit from the new rate or end up paying much more over time.
Home equity loans and home equity lines of credit (HELOCs) are other types of home loans. A home equity loan is a second mortgage, which allows you to borrow against the equity you’ve accumulated in your home. A home equity loan’s interest rate is set when you borrow and usually remains the same for the life of the loan. With a HELOC, you get a line of credit from the home equity you’ve built up that you can borrow from at any time. It’s sort of like a credit card, with your home equity as the source of funding. You only pay interest on the amount you use from the money you’re able to borrow from.
HELOCs usually have a variable rate, which means the monthly payment can change over the loan’s lifetime. There are fixed-rate HELOC options, but they tend to have higher interest rates.
With these types of home loans, you should consider how long you’ll be borrowing, what type of monthly payment you can make and how quickly you want to pay off the loan. These can all affect how much interest you’ll pay over time.
The Final Word
With interest rates affecting everything from savings accounts to credit card debt to home loan payments and loans for things like opening up a business, it’s important to pay attention to interest rates and compare your options. Factors like time, the amount of principal, frequency of payments or investments and how much you plan to pay or save every month all impact how much you stand to make or pay.