Definition
Interest rates are the percentage of a loan that a lender charges for borrowing money. The interest rate is the cost you pay each year to borrow money, and is typically represented as an annual percentage rate (APR). Lenders use different methods to calculate interest rates, but the most common is the prime rate plus a margin. The prime rate is the interest rate that banks charge to their most creditworthy customers. The margin is the lender’s profit.
Interest Rates
An interest rate is the percentage of principal charged by the lender for the use of its money. Interest rate is due per period, as a proportion of the amount lent, deposited, or borrowed. The total interest on an amount lent or borrowed depends on the principal, the interest rate, the compounding frequency, and the length of time the money is lent, deposited, or borrowed.
How Interest Rates Work
The bank applies interest rate to the total unpaid portion of your loan or credit card balance. You must pay at least the interest each month. If not, your outstanding debt will increase even though you are making payments.
Not all interest rates are the same. A bank will charge higher interest rates if it thinks there’s a lower chance the debt will get repaid. For that reason, banks will assign a higher interest rate to revolving loans such as credit cards.
These types of loans are more expensive to manage. Banks also charge higher interest rates to people they consider risky. The higher your credit score, the lower the interest rate you will have to pay.
Interest Rate Terms To Know
- Base Rate: the annualized rate offered on overnight deposits by the central bank or other monetary authority
- Annual Percentage Rate (APR): is the interest rate for a whole year, rather than just a monthly fee/rate, as applied on a loan, mortgage loan, credit card, etc.
- Annual Equivalent Rate (AER): interest rate on a loan or financial product restated from the nominal interest rate and expressed as the equivalent interest rate if compound interest was payable annually in arrears.
- Coupon Rate: ratio of the annual coupon amounts (paid per year) per unit of par value
- Current Yield: ratio of the annual coupon divided by current market price
- Yield to Maturity: a bond’s expected internal rate of return, assuming it will be held to maturity.
Types of Interest Rates
There are 7 types of interest rates, all with varying uses and purposes.
1. Fixed Interest
A fixed interest rate is a specific, fixed interest tied to a loan or line of credit that must be repaid along with the principal. A fixed interest rate is the most common form of interest for consumers, as they are easy to calculate, understand, and stable.
2. Variable Interest
Variable interest is typically tied to the ongoing movement of base interest rates. Borrowers can benefit if a loan is set up using variable rates, and the prime interest rate declines. The opposite is true as well; if prime interest rates go up, so does the percentage of interest the borrower must pay.
3. Annual Percentage Rate (APR)
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 easy to calculate: its the prime rate plus the margin the bank/lender charges the consumer. The result is the annual percentage rate.
4. The Prime Rate
Prime rate is the interest that banks often give favored customers for loans, as prime rates tend to be relatively lower than the usual interest rates 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 one another.
5. The Discount Rate
The discount rate is the interest rate the U.S. Federal Reserve uses to lend money to financial institutions for short-term periods. This rate is usually walled off from the public view.
6. Simple Interest
Simple Interest is a rate banks commonly use to calculate the interest rate they charge borrowers. Like APR, the calculation of simple interest rate is basic.
7. Compound Interest
Compound interest is calculated on an annual basis. Lenders include that interest amount to the loan balance and use the amount in calculation the next year’s interest payments on a loan. This is also known as “interest on the interest.”
Who Determines Interest Rates?
In the past two centuries, interest rates have been variously set either by national governments or central banks. Central banks determine short-term interest rates, and is routinely checked to ensure the supply of money in the economy is neither too large (which causes prices to increase), nor too small (which causes prices to drop).
In the United States, interest rates are determined by the Federal Open Market Committee (FOMC), which consists of seven governors of the Federal Reserve Board and five Federal Reserve Bank Presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates.
Long term interest rates are determined by the demand for treasury notes. Many of these are independent of the Federal funds rate, and instead follow a 10-year or 30-year Treasury note yield.
These yields depend on demand after the U.S. Treasury Department auctions them off on the market. Lower demand results in higher interests rate, whereas higher demand results in lower interest rates.
