Easiest Way to Explain What an Interest Rate Is

Learn about all the different types of interest rates and how to explain it to others.

 

Interest comes in different forms, but essentially, it represents the cost of using someone else’s money. When you borrow money the interest rate is the amount a financial institution charges you for the loan — and its number is expressed as a percentage. When you open a savings or checking account, the financial institution gives you interest for keeping your money, and that number is also expressed as a percentage.

Find out how interest works by reviewing these specific types of interest rates you will come across so you understand why you get the interest rates you do and so that you can explain it to others, such as your co-borrower or co-signer.

Prime Interest Rate

The prime rate is a common, short-term interest rate the U.S. banking system uses. Individual banks set the prime interest rate and generally base it partially on the target level of the federal funds rate. Banks and other lending institutions can add to this rate to make a profit, or subtract from it to compete with other lenders.

If you want to explain prime interest rates to someone use an example of a home equity line of credit. Compare the current HELOC interest rates from a variety of lenders. You’ll see that some rise above the prime interest rate of 4 percent, some fall below and others use the exact rate.

Fed Interest Rate

Fed interest rates, also called federal fund rates, represent the percentage that one bank charges another for the overnight use of its money. The Federal Reserve System’s Federal Open Market Committee sets the fed interest rates, which are designed to help control inflation and promote a healthy economy.

To communicate what a fed interest rate is, talk about the trickle-down effect that occurs when the rate changes. Whether the fed rate increases or decreases other rates inevitably follow, including foreign exchange rates and the price of goods and services.

When fed rates are low, banks typically make more loans. When the rates rise, you’ll get better bank interest rates for your savings account.

Related: 2017 Interest Rate Forecast — How the Fed Rate Hike Will Impact You

Mortgage Rate

When you get a mortgage you’ll be charged an interest rate on the money you borrowed — it will be expressed in a percentage. That interest rate is the yearly cost you pay for borrowing the money, according to the Consumer Financial Protection Bureau.

The Federal Truth in Lending Act requires every lender to clearly list all the terms of the loan, including the mortgage interest rates and an accrued interest table. If you’re explaining mortgage rates to a friend or someone in your family, make sure you tell them to review these terms carefully and to compare mortgage rates from several lenders to get the best deal.

Understand Two Types of Savings Interest Rates

Because savings account interest rates and CD interest rates fluctuate based on the economy, their rates today might not be the same as tomorrow. If you’re discussing savings interest rates with your spouse to prep for retirement, explain that there are two different kinds:

  1. Simple interest: Simple interest is based on the amount of money you deposit into your account. The simple interest formula is S = P(r)(t). P represents the principle, r the rate and t the time. Using this formula, you’ll find that an account with $1,000 in it and a 3 percent yearly interest rate will earn you $30 in interest.
  2. Compound interest: Compound interest is a more complicated than simple because it includes interest on your deposits as well as the interest you’ve already accumulated. The compound interest formula is C = P[(1+r)^n-1]. P represents the principal, r the rate and n the number of the period to which the interest rate applies. An account with $1,000 in it and a 3 percent rate for the period of one year would earn you $30.42 in interest, which is $.42 more than you’d get with simple interest.

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