Interest is the grease that that gets the credit and lending trains rolling, and is an integral part of the way money moves in the financial sector.
The broad definition of interest is straightforward.
Interest is the additional payment, called the interest rate, on top of the principal paid to a lender for the right to borrow money. The interest rate is expressed as an annual percentage rate, and the payment could be a fixed amount of money (fixed rate) or rates paid on a sliding scale (known as a variable payment.)
Basically, interest is the toll you pay to travel on the credit highway, at a specific price and for a specific period of time.
Know these five keys about interest when you're applying for credit or taking out a loan:
- The amount of interest paid depends on the terms of the loan, worked out between the lender and the borrower.
- Interest represents the price you pay for taking out a loan - you still have to pay off the base principal of the loan, too.
- Interest on loans is usually pegged to current banking interest rates.
- Your interest rate on a credit card, auto loan or another form of interest can also depend largely on your credit score.
- In certain cases, like with credit cards, your interest rate can rise if you're late on a payment, or don't make a payment.
If you dig down into the interest landscape, you'll see that there are multiple forms of interest that may confront a borrower. Thus, it's in the best interest of a borrower to get to know the various types of interest and how each may impact the acquisition of credit or a loan.
After all, the more knowledge gained from better understanding interest, and how it works in all of its forms, can be leveraged to get you a better deal the next time you apply for a loan or a credit account.
Here's a breakdown of the various forms of interest, and how each might impact consumers seeking credit or a loan.
1. Fixed Interest
A fixed interest rate is as exactly as it sounds - a specific, fixed interest tied to a loan or a line of credit that must be repaid, along with the principal. A fixed rate is the most common form of interest for consumers, as they are easy to calculate, easy to understand, and stable - both the borrower and the lender know exactly what interest rate obligations are tied to a loan or credit account.
For example, consider a loan of $10,000 from a bank to a borrower. Given a fixed interest rate of 5%, the actual cost of the loan, with principal and interest combined, is $10,500.
This is the amount that must be paid back by the borrower.
2. Variable Interest
Interest rates can fluctuate, too, and that's exactly what can happen with variable interest rates.
Variable interest is usually tied to the ongoing movement of base interest rates (like the so-called "prime interest rate" that lenders use to set their interest rates.) Borrowers can benefit if a loan is set up using variable rates, and the prime interest rate declines (usually in tougher economic times.)
That said, if base interest rates rise, then the variable rate loan borrower may be forced to pay more interest, as loan interest rates rise when they're tied to the prime interest rate.
Banks do this to protect themselves from interest rates getting too out of whack, to the point where the borrower may be paying less than the market value for interest on a loan or credit.
Conversely, borrowers gain an advantage, too. If the prime rate goes down after they're approved for credit or a loan, they won't have to overpay for a loan with a variable rate that's tied to the prime interest rate.
3. Annual Percentage Rate (APR)
The annual percentage rate is the amount of your total interest expressed annually on the total cost of the loan. Credit card companies often use APR to set interest rates when consumers agree to carry a balance on their credit card account.
APR is calculated fairly simply - it's the prime rate plus the margin the bank or lender charges the consumer. The result is the annual percentage rate.
4. The Prime Rate
The prime rate is the interest that banks often give favored customers for loans, as it tends to be relatively lower than the usual interest rate offered to customers. The prime rate is tied to the U.S. federal funds rate, i.e., the rate banks turn to when borrowing and lending cash to each other.
Even though Main Street Americans don't usually get the prime interest rate deal when they borrow for a mortgage loan, auto loan, or personal loan, the rates banks do charge for those loans are tied to the prime rate.
5. The Discount Rate
The discount rate is usually walled off from the general public - it's the interest rate the U.S. Federal Reserve uses to lend money to financial institutions for short-term periods (even as short as one day or overnight.)
Banks lean on the discount rate to cover daily funding shortages, to correct liquidity issues, or in a genuine crisis, keep a bank from failing.
6. Simple Interest
The term simple interest is a rate banks commonly use to calculate the interest rate they charge borrowers (compound interest is the other common form of interest rate calculation used by lenders.)
Like APR, the calculation for simple interest is basic in structure. Here's the calculus banks use when determining simple interest:
Principal x interest rate x n = interest
For example, let's say you deposited $5,000 into a money market account that paid a 1.5% for three years. Consequently, the interest the bank saver would earn over the three- year period would be $450 < x .03 x 3 = $450.>
7. Compound Interest
Banks often use compound interest to calculate bank rates. In essence, compound rates are calculated on the two key components of a loan - principal and interest.
With compound interest, the loan interest is calculated on an annual basis. Lenders include that interest amount to the loan balance, and use that amount in calculating the next year's interest payments on a loan, or what accountants call "interest on the interest" of a loan or credit account balance.
Use this calculus to determine the compound interest going forward:
Here's how you would calculate compound interest:
- Principal times interest equals interest for the first year of a loan.
- Principal plus interest earned equals the interest for the second year of a loan.
- Principal plus interest earned times interest equal interest for year three.
The key difference between simple interest and compound interest is time.
Let's say you invested $10,000 at 4% interest in a bank money market account. After your first year, you'll earn $400 based on the simple interest calculation model. At the end of the second year, you'll also earn $400 on the investment, and so on and so on.
With compound interest, you'll also earn the $400 you receive after the first year - the same as you would under the simple interest model. But after that, the rate of interest earned rises on a year-to-year basis.
For example, using the same $10,000 invested at a 4% return rate, you earn $400 the first year, giving you a total account value of $10,400. Total interest going forward for the second year isn't based on the original $10,000, now it's based on the total value of the account - or $10,400.
Each year, the 4% interest kicks in on the added principal and grows on a compound basis, year after year after year. That gives you more bang for your investment buck than if the investment was calculated using simple interest.
Whether you're a borrower looking for a better deal on a home loan or credit card, or you're an investor looking for a higher rate of return on an investment, getting to know interest rates, and how they work is vital to maximizing loan and investment opportunities.
One day, you may need to make a big decision on one of them, with your money on the line.