What Are Interest Rates and How Do They Work?
Higher interest rates, as a term, is a double-edged sword. If it is associated with your savings or CD account it is a good thing, however, if it is the amount of money you pay on your credit card bill, not so much.
You may be aware of how the Federal Reserve is increasing interest rates, but what are interest rates exactly? And how do they affect your financial life?
What Is an Interest Rate?
In simple terms, there are two ways interest rates can be defined and those fall into the camps of interest you pay or the interest you earn. It can either be the amount you are charged on a loan when you borrow money or the payment you receive on money you have deposited. It is expressed as a percentage that is considered the cost of borrowing or the benefit of saving.
How Do Interest Rates Work?
With deposit accounts, your bank, credit union or other financial institution will pay you money. This is known as annual percentage yield or APY. When borrowing money, the interest rates you pay will fund the rates banks pay on deposit accounts. Essentially, when a bank loans you money, the interest you pay will be used to fund a bank loan to someone else. This will typically be at a higher rate thus making it a cycle of financing.
APY vs. APR
A good way of understanding the difference between the interest you earn versus the interest you owe is knowing what APY and APR mean.
- Annual percentage yield: The rate you earn on a deposit account such as savings, CDs or money market accounts. APY is done over a period of a year and includes compound interest.
- Annual percentage rate: APR is the interest you pay on an account as well as any fees. This percentage is also calculated on a yearly basis.
Common Areas Where You Earn Interest
Deposit accounts, or accounts where you save or invest money, often offer the incentive of paying an APY. This rate is usually competitive or higher than other banks or credit unions. The following are examples of accounts where you get paid interest:
- Savings accounts
- High-yield savings accounts
- Certificates of deposit
- Money market accounts
Common Areas Where You Pay Interest
When you borrow money or take out either a short-term or long-term loan, it will have an APR attached. You’ll have to pay the APR on top of the loan estimate and closing costs. Here are common areas where you would pay interest:
- Mortgage interest rates
- Mortgage insurance
- Student loans
- Cash advances
- Credit cards
What Determines Interest Rates?
On a national average, the Federal Reserve sets the federal funds rate. This rate is reassessed eight times a year and is affected by several factors such as economic growth and conditions like inflation.
For personal banking, when you borrow money, the interest rate you are offered can be affected by factors like your credit score or how much down payment you can afford. For example, if you have a higher credit score and a good amount of cash to put down, you will likely receive a lower interest rate. You would be a higher risk with a poor credit score or less money for the deposit.
Benchmark Interest Rates
Interest rates can fluctuate depending on things like current economic conditions or your credit score. Many financial institutions or products will base rates on benchmark interest rates. Benchmark rates are determined by both economic growth and inflation. Here are two styles of benchmarks set by the Federal Reserve and prime rates set by banks.
- High benchmark rates: These rates indicate a higher cost to borrowing money and regulating activity that can increase inflation.
- Low benchmark rates: These rates are designed to encourage borrowing and spending activity in hopes of boosting economic growth.
Final Take To GO
Whether it is earning on a high-yield savings account or paying on a 30-year fixed-rate mortgage, knowing what is an interest rate and how they work is imperative. A good interest rate can mean a lot of different things depending on which account it comes with and whether you are paying or earning. Seek out high-interest rates when looking to open a savings account or CD, and make sure to research the lowest interest rates when it comes to taking out a mortgage or applying for a new credit card.
FAQHere are some answers to frequently asked questions about what interest rates are and how they work.
- What is an interest rate in simple terms?
- Interest rates are qualified in two different ways. The first is the amount you are charged on a loan when you borrow money. The second is the money you earn on a deposit account. It is expressed as a percentage of either APY or APR.
- How do interest rates work?
- When a bank loans you money, the interest you pay is part of what will be used to fund a bank loan to someone else. This will typically be at a higher rate, thus making it a cycle of financing. With deposit accounts, your bank, credit union or other financial institution pays you money. This money is known as annual percentage yield or APY. When borrowing money, the interest rates you pay will fund the rates banks pay on deposit accounts.
- What is a good interest rate?
- What is considered a good interest rate depends on which account you are applying it to. For example, a lower interest rate is desirably on a loan, whereas a higher interest rate is preferred on a savings account.