Have you ever wondered how your bank decides how much to charge you on your mortgage or credit card? Have you ever looked at an account statement and failed to understand what all of the jargon meant?
Read on for a step-by-step guide on how your bank calculates how much to charge you.
How Does Interest Work?
Interest is one of the ways lenders make their money, and it’s what makes it worth it for them to give out loans. If you’re borrowing money, interest is the cost the bank charges you for the service.
On the flip side, if you’re stashing your money in a savings account, you’re technically loaning the bank your money — so the bank pays you interest. However, banks usually pay much lower interest rates on savings accounts than they charge on credit cards and loans.
Interest vs. APR
Interest is usually given as a percentage per year. For example, if you take out a $1,000 loan at 10% interest, the bank will charge you $100 each year. The actual calculations may be more complicated since the bank will split the payments over time during the year.
If you’ve ever seen an offer for a credit card or a loan, you may be familiar with annual percentage rates. The APR represents the total yearly cost of borrowing money, including both the interest rate and any additional fees or charges associated with the loan. This means that the APR is the “real” yearly cost of your loan.
Banks are legally required to tell you the APR of a loan so any additional fees don’t catch you by surprise.
How Do Banks Decide How Much Interest To Charge?
One of the most important factors that determines the interest on your loan or credit card is the U.S. Federal Reserve. That’s because a regular consumer bank has to get the money it lends you from somewhere. Banks borrow from the Federal Reserve and then lend that money to you, for a higher price.
This means that if the Fed raises the rate it charges, banks will also raise what they charge you. The Fed can either raise rates to fight inflation or lower them to boost the economy. How much extra the bank will charge you on top of the Federal Reserve’s interest rate will depend on the type of loan and your financial situation.
Secured vs. Unsecured Loans
Different loans carry different levels of risk and administrative costs for the bank. Secured loans like a mortgage or auto loan will typically have lower interest rates because secured loans are backed by collateral. If you default on a mortgage or auto loan, the bank can legally repossess the house or car and sell it to get its money back.
Unsecured loans, such as credit cards and personal loans, have no collateral and therefore pose a higher risk to the lender. If the bank wants to get its money back, it may have a longer legal process to go through, with a lower chance of success and more costs involved.
In those cases, the bank usually sells your debt to a debt collection agency, which means it may take a loss on your loan. This higher risk for the bank means that these types of loans often come with higher interest rates.
Your Finances and Credit Score
Banks assess your creditworthiness by examining your credit score, credit history, income, employment stability and debt-to-income ratio. A higher credit score indicates a lower risk of default, which can qualify you for a lower interest rate.
Fixed vs. Variable Interest Rates
A fixed interest rate remains the same throughout the life of the loan or investment. Whatever the rate was when you got the loan, that’s the rate you’re going to have for the loan’s duration.
A variable interest rate can change over time based on market conditions and the Federal Reserve’s rates. While variable rates may start lower than fixed rates, they could increase significantly, leading to higher payments.
A fixed rate will usually be a bit more expensive than a variable rate since it’s a higher risk for the bank. However, if interest rates are currently relatively low, like they were from 2020 to 2021, a fixed-rate loan can be a good deal, especially on a mortgage.
How Banks Calculate Interest on Different Products
Credit Cards
- Credit cards typically use a variable APR.
- Interest on credit cards accrues daily on any unpaid balances.
- The daily interest rate is calculated by dividing the APR by 365 days.
Auto Loans
- Banks calculate interest on auto loans using an amortization schedule, through which part of your payment goes to paying off the value of the car and the rest goes toward interest.
- The interest portion is higher at the beginning of the loan and decreases over time.
- The monthly payment will be calculated using a combination of the loan amount, interest rate and duration of the loan.
- Online calculators can be a good way to figure out what makes up your current monthly car payment.
Mortgages
- For fixed-rate mortgages, the bank calculates interest similarly to auto loans, using an amortization schedule with a fixed interest rate for the entire term.
- Adjustable-rate mortgages have interest rates that can change at specified intervals. The initial rate is usually fixed for a period of a few years, after which it begins to adjust.
Personal Loans
- Personal loans may use simple or compound interest and can have fixed or variable interest rates.
- Your bank will calculate your monthly payments based on the loan amount, interest rate and repayment term.
Bank Fees
Banks can charge various fees for services, account maintenance and late payments. Common fees include overdraft fees, service fees, late-payment fees and ATM fees.
You should always read the fee schedule and account agreements provided by your bank so that you know what to expect. Here’s a breakdown of the various fees.
Overdraft Fees
- An overdraft fee is charged when you withdraw more money from your account than the available balance.
- Overdraft fees vary by bank, but they usually cost around $35 per occurrence.
- Multiple overdrafts can result in multiple fees.
- Note: The Consumer Financial Protection Bureau has ruled that it’s illegal for banks to charge you an overdraft fee if you haven’t opted into overdraft services. If you have been charged an overdraft fee, you may be able to get it removed by calling your bank.
Service Fees
- Monthly maintenance fees are charged for account services.
- Some banks waive these fees if you meet certain criteria, such as maintaining a minimum balance or setting up direct deposits.
Late-Payment Fees
- Late-payment fees apply when you miss the payment due date on a loan or credit card.
- The fee amount depends on the bank and the type of account.
- Paying on time helps you avoid these fees and can positively impact your credit score.
ATM Fees
- Using an ATM outside your bank’s network can result in fees from both your bank and the ATM owner.
- ATM fees have recently gone up, with an average of $4.77 per transaction.
- To minimize these costs, use your bank’s own ATMs or choose accounts that reimburse out-of-network ATM fees.
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