By: Shelly Gigante
Shelly Gigante specializes in personal finance issues. Her work has appeared in a variety of publications and news websites.
This article will...
Explain what interest rates are and how they are set.
Note the two different ways interest rates can be determined on a loan or deposit.
Discuss how to compare interest rate offers and understand what factors will affect the interest rates you receive.
Interest rates have a profound effect on consumers. They set the cost of borrowing money, determining how much you’ll actually pay to buy a house or a car or carry a credit card balance. Interest rates also dictate how quickly your savings and certain investment accounts may grow over time, potentially helping you reach your financial and retirement goals.
So, it is important to understand how interest rates work and how they affect you. That includes knowing:
- How the federal funds rate differs from the prime rate.
- How interest rates apply to consumers (simple vs. compound interest).
- Why APR and APY are important.
- How your credit score affects the cost of a loan.
First, let’s look at where interest rates come from.
The federal funds rate versus the prime rate
The starting point for discussing interest rates is the federal funds rate, which is set by the Federal Reserve. Essentially, the federal funds rate is the interest rate that commercial banks charge each other for short-term (overnight) loans.
The federal funds rate impacts Main Street America in two ways:
- It influences what yields banks offer on savings accounts and certificates of deposit to attract savers.
- It is used to determine the prime rate.
The prime rate, typically higher than the federal funds rate, is the interest rate that commercial banks and credit unions charge their best customers (as determined by their credit rating) for:
- New loans, including home and auto loans, personal loans, and small-business loans.
- Existing loans with a variable APR, including adjustable-rate mortgages (ARMs), home equity lines of credit, and most credit card balances.
So, the federal funds rate influences the prime rate, which, in turn, sets the basis for what interest rate banks charge borrowers for loans — or pay savers for deposits.
But what a consumer actually pays or receives in interest will likely not be the prime rate.
- In the case of savings, the yields offered by banks, while based on the prime rate, can be influenced by the general investment environment and competition from other financial vehicles or institutions.
- In the case of loans, interest rate charges can be influenced by a variety of factors, such as the collateral available to secure it and the borrower’s credit history (discussed below).
Additionally, the amount of money actually paid on a loan will be affected by the type of calculation, simple or compound, used to apply the interest rate.
Simple interest versus compound interest
For consumers, interest rates materialize on loans or savings in two ways:
- Simple interest
- Compound interest
The difference between the two methods can be significant.
Simple interest is calculated on the original amount of the loan or deposit over the set term (loan or deposit multiplied by the interest rate multiplied by the term). So, a loan of $10,000 at a fixed yearly 8 percent interest rate would have an annual payment of $800. If the term of the loan is three years, then the total cost of the loan is $2,400 or three annual payments of $800.
Compound interest is calculated on the principal amount of the loan or deposit, plus accrued interest up to the payment time. Essentially, you are paying or earning “interest on the interest” in addition to the principal. This makes the calculation a little more complicated because the annual payment changes from year to year.
Indeed, for the loan above — $10,000 at an 8 percent interest rate, but compounded annually — the payments would be:
- Year 1: $800
- Year 2: $864
- Year 3: $933.12
This would make the total cost of the loan $2,597.12.
In this simple example, the difference between the two methods of calculating interest charges — simple interest versus compound interest — is almost $200. This is why a loan costs you more when it has compounded interest charges. (Conversely, you earn more on savings when interest on your deposit is compounded.)
This loan example doesn’t take into account the actual repayment of the principal — just how much the loan would cost. Often, loan repayment plans prescribe payments that blend interest rate charges with principal repayment, depending on the terms.
Also keep in mind that this example is simplified using annual compounding. Interest charges on loans and deposits can be compounded on a monthly or even daily basis. And they often are, given that compounding is the more common method applied to consumer loans.
So, given the complexity of determining interest rate compounding, how can consumers measure what loans are likely to cost over time or what deposits in various type of financial accounts are likely to earn? That’s where APR and annual percentage yield (APY) become important.
Why APR and APY are important
APR is a useful tool when shopping for loans. According to credit rating agency Equifax, APR represents the total annual cost of borrowing money, reflected as a percentage of the principal loan amount.
The APR includes all costs associated with your loan, such as closing costs and origination fees in the case of a mortgage. While it does not take compounding into account, it provides the most complete picture of the cost of borrowing money and, as such, is the best yardstick with which to compare loans.
The equivalent barometer for savers is the annual percentage yield, or APY.
Savers benefit when banks raise interest rates because they earn a higher yield on their savings, including money market accounts and certificates of deposit.
When interest rates fall, banks tend to offer lower yields on deposits and savers earn less on the money they keep in banks.
The APY helps consumers compare rates of return on savings accounts and investments. APY factors in compounded interest, which, as noted above, occurs when you earn interest not only on your principal savings balance, but also on any previous interest earned.
How your credit score affects the cost of a loan
Finally, a word about creditworthiness.
Lenders charge borrowers an interest rate based on their credit score, a number that reflects their likelihood to repay their debt.
Your credit score is a numerical rating that is determined, in part, by your repayment history. If you missed payments on a prior loan, your credit score will be lower and, in some cases, significantly lower, which means you’ll pay more to borrow money.
According to the American Bankers Association, other factors that account for consumer credit scores include credit utilization rate (the amount of credit you use relative to your credit limits), the length of your credit history, the types of loans you have, and new credit requests. If you apply for several new accounts in a short period of time, it’s a red flag to lenders.1
FICO and VantageScore are the most commonly used credit scores. They range from 300 to 850. The higher your credit score, the lower the interest rate you will pay.
According to the National Foundation for Credit Counseling, anyone with a score below 600 — considered subprime — should focus on raising their score to help reduce the cost of borrowing money.
You can check your credit report for free, an action that does not impact your credit score, on any or all of the three major credit rating agencies (Equifax, Experian, and TransUnion) on their annualcreditreport.com website.
The best way to raise your score is to:
- Keep the number of credit cards you have low.
- Have a diverse range of debt.
- Stay well below your credit ceiling.
- Pay off credit cards and close the account, to reduce your number of cards.
These steps may take effort and time. But achieving and maintaining a so-called healthy credit score gives you access to better interest rates on your mortgage, car, credit card, or personal loan.
Interest can have a profound effect on your household spending and saving.
Borrowers who are looking for loans and those with existing variable rate debt (including credit card balances and ARMs) should follow interest rates closely to be sure that they can afford their monthly payments, while taking steps to optimize their credit score for the most favorable rates.
Savers, meanwhile, should monitor interest rates on savings and investment products to help maximize their rate of return.
A financial professional can provide valuable guidance on the savings vehicles that are right for you, as well as provide tips for managing debt.
