Interest Rates: How They Work, and How to Calculate Them

Interest Rates: How They Work, and How to Calculate Them
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Point editorial

Always present and always notorious, interest rates are a frequently discussed topic in the financial realm. Interest is the percentage amount that a lender charges for the use of their money. In other words, it’s the additional amount that a borrower must pay for a loan. 

The size of a loan will influence the interest rate. Common examples of loans include mortgages, student loans, and auto loans. 

Interest rates also apply to money in saving accounts, as banks will pay you interest on the funds you choose to deposit with them. Unfortunately, interest rates in this context are not high. Typically, interest rates will be less than one percent. Nevertheless, reinvesting what you earn in interest into your savings, no matter the amount, can help you make more money over an extended period. 

Read on as we discuss interest rates in further detail, including why they’re important and what types of rates exist.

Why do interest rates matter?

Dealing with interest rates on a personal level can be trying, but tracking these rates can help identify growth and declines in the economy on a macro level. 

They also help dictate borrowing rates. Lower interest rates mean more people can and will borrow money for larger purchases, in turn helping businesses to grow. When rates are higher, people aren’t as willing to take out loans, and companies can suffer the consequences. 

Understanding how interest rates work

Interest rates apply to the portion of a loan that is unpaid. When it is time to pay your bills, you are required to pay, at the very least, the amount of interest you owe; otherwise, your debt will increase. 

Lenders usually determine rates, so it’s important to remember that not all lenders set the same rates. But they are all competitive, nonetheless. 

Continual or revolving loans such as credit card loans tend to have higher rates. Individuals who display “risky financial behavior” are also charged with higher rates. Those who possess a higher credit score are offered lower rates because of their good credit history and decisions. 

The Federal Reserve determines the threshold for national interest rates. Treasury yield notes also influence this as well. Treasury notes are loans made to the US government and only last for 10 years. High demand for these notes leads to lower interest rates, while low demand can lead to increased rates to make up for the loss in capital.

A glance at APR

APR stands for annual percentage rate and refers to the overall cost of a loan. Overall loan costs include the interest rates, points, or one-time fees that you can pay up front to secure a lower interest rate, and the cost of closing a loan. 

APR is useful for comparing loan costs, as it allows you to apply for loans that are the most beneficial for your situation.

Fixed and variable interest rates

Fixed interest rates are rates that remain constant for the duration of your loan. Examples include mortgage payments and personal loans. 

In comparison, variable interest rates are rates that are subject to change. When a rate rises, so do your loan payments and vice versa. Mortgages can also have variable interest rates, as can credit card loans and bonds. 

Simple interest and compound interest 

Simple interest 

Simple interest is the interest that accompanies the initially agreed-upon loan amount. Experts also call this fixed percentage the “principal amount.” 

The following formula shows how to calculate simple interest: 

P x r x n = simple interest

P” represents the principal amount, “r” is the annual interest rate, and “n” is the duration of your loan in years. 

Student loans and car loans are two well-known examples of loans with simple interest rates. 

Compound interest 

Compound interest rates are rates that accumulate over time. To calculate compound interest, lenders use the following formula.

P x (1 + r)t P = compound interest

Similar to the simple interest formula, “P” stands for the principal amount, “r” is for the annual interest rate, and “t” is the number of years the interest is applied. 

Essentially, in addition to paying the principal amount for a loan, you are also paying interest on the interest. Examples include credit cards and mortgage payments. 

How do credit scores affect interest rates? 

Again, a higher credit score indicates good financial health. It gives banks more confidence in your ability to pay back loans, leading them to give you lower interest rates. 

A lower credit score suggests uncertain behavior, so a higher interest rate is a way for a bank to compensate for taking risks in entering relationships with certain borrowers. 

Point’s contributions 

Point Card is available to everyone who wants to control their own money and earn rewards without dealing with the hassles of a credit card. Not only does this debit card give you new purchase insurance, but you’ll also get travel benefits like global assistance and no international fees. In addition, Point Card  earns you unlimited cash-back on all purchases, and bonus cash-back for subscriptions, food delivery, rideshare services, and coffee shops. So, as you work hard to maintain good financial health, Point is working just as hard for you.

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