If you’ve ever made a student loan payment or carried a credit card balance into a new month, you already know how interest rates work.
In those cases, it’s the percentage tacked onto your principal debt, or the price you pay later for borrowing money now.
These rates are intertwined with every aspect of our personal financial lives. Here’s your primer (or reminder) on how interest adds to all of life’s financial balances.
1. Understanding the Federal Funds Rate
The federal funds rate (FFR), the interest rate of all interest rates, is calculated by the Federal Reserve and determines how much a bank needs to pay if it borrows money from another bank. The FFR also determines the rate at which a bank lends to (or borrows from) you. When the FFR increases or decreases, the interest rates for the rest of the personal finance decisions on this list also shift.
When the FFR is low, banks can offer lower interest rates to consumers, so we’re all incentivized to borrow, which means we’re more likely to spend. When the FFR is high (and consequently, interest rates are high), we’re not.
2. Using a Credit Card
The APR, or annual percentage rate, is the rate at which your card issuer charges you interest every year. They might offer a range of 15% to 21%, for example.
Although the card’s APR is affected by rates like the FFR, it’s also determined by the issuer and your credit history. A stronger credit history qualifies you for lower APRs on credit cards, including rewards cards.
Part of the reason that credit card users can end up in debt quickly is that credit card interest is calculated daily. This means it costs you extra money every day you maintain a credit card balance.
Just to make things more complicated, the interest rate on your credit card is itself variable, meaning it could go up at a month’s notice. On the bright side, you could always ask your issuer for a lower rate—and if your credit is good, you could qualify for one.
3. Taking Out or Refinancing a Student (or Personal) Loan
If you pay off your loans early, you can save on interest. Increasing your payment by $50 per month when you have $35,000 in debt with a 5.7% interest rate, for example, would shave 16 months and $1,749 of interest off your loan. A student loan prepayment calculator can show you how much could be saved in any situation.
The interest rate of student loans is more complex than that of credit cards. As with credit cards, your creditworthiness affects the fixed or variable APR you might be offered when taking out a private student loan or personal loan. You could also score a better rate by doing any of the following:
- Having a good debt-to-income ratio
- Including a co-signer who has a strong credit report
- Setting up auto-pay as part of your repayment plan
Lenders’ rate ranges are typically dependent on either the prime rate set by the Federal Reserve or the London interbank offered rate (Libor).
Federal student loans are different, however, and the interest rates of federal loans are determined by Congress. Between July 2017 and July 2018, for example, an undergraduate could take out a Direct Unsubsidized Loan with a 4.45% interest rate or resort to a private lender offering rates between 3% and 12.5%.
The advantage of federal loans is that rates are fixed across the board and that some of these loans are subsidized, meaning the government picks up the tab on interest while the borrower is in school. Upon graduation, however, some borrowers benefit from finding a lower interest rate on a refinanced loan.
4. Buying or Leasing a Car
Unless you have the cash, borrowing money helps you cover the gap between your down payment and the total cost of a car. Instead of figuring out your loan at the dealership, though, you may be better served by visiting your local bank or credit union first. This way, you can walk into a car dealership already having received a rate quote, which can give you more leverage in negotiation.
In addition, the dealership, like a credit card issuer or student loan company, considers your credit score when determining what interest rate it can offer. A car buyer with poor credit could see rates 11 percentage points higher than a more creditworthy peer, according to 2017 data from Experian. The interest rate on these sorts of subprime loans could reach upwards of 30%.
If that deters you from buying, be aware that leasing a car has its own set of rules for interest. Money factor is a term you’ll hear salespeople throw around. It’s an interest rate that helps determine your monthly payment on a leased vehicle. To see the equivalent in APR, multiply the money factor amount by 2,400.
5. Buying a Home
Buying a car is a big deal, sure, but buying a home is probably the biggest financial decision you’ll make in your lifetime. Because it also requires borrowing, it’s subject to the world of interest rates.
With fixed and variable mortgage rates, every percentage point matters. There’s a big difference between even a 4% and a 5% interest rate, as any home mortgage calculator can tell you. If you borrow $150,000 at 4%, for example, you’ll pay $160,205 in interest over a 30-year mortgage. Borrowing at 5% would instead cost you $192,284 in interest.
Here are some other things that could help you qualify for a lower interest rate:
- Saving up a larger down payment
- Having a shorter mortgage term
- Sporting a superb credit score
With homebuying, it’s especially important to understand the difference between interest rates and APR. The latter includes the interest rate on your loan, plus other homebuying costs such as broker fees.
Both interest rates and APRs can be used to compare loan quotes, as long as you’re making apples-to-apples comparisons and comparing similar elements of each kind of loan.
6. Earning Bank or Stock Dividends
Whether you’re using a credit card to make a small purchase or a loan to make a bigger one, you’re borrowing money. But in the case of your savings and investments, you’re actually the lender. Banks pay interest in the form of annual percentage yield (or APY) for the right to hold (and shift) your money around.
These interest rates vary across account types. A legacy savings account, for example, might pay you as little as 0.01% for your money. A high-yield online savings account, meanwhile, could pay you as much as 1%. Compounding, which is accounted for in APY but not APR, occurs when your interest earns interest.
When the FFR is increased, it might be bad news for borrowers, but it’s good news for savers. As the FFR goes up, interest rates on savings vehicles like certificates of deposit, or CDs, will likely climb. And just as compound interest can increase your debt on a loan, it can increase your dividends on a bank account.
Keep Interest Rates in Mind for Every Big Decision
Interest rates are a part of the fabric of every personal finance decision in our lives. Just being more aware of interest rates in general can save you time when comparing bank offers. It could also save you thousands of dollars in debt—or even help your money grow faster. Whether you’re borrowing money for your education or perhaps saving up to finance your child’s, understanding how interest works is imperative. Before any big money decision, though, it’s a good idea to check your credit score.