Interest Rate: Definition, Applications, and Purpose

Different Kinds of Interest Rates and What They Mean for People Who Borrow

An interest rate is the cost of borrowing money. It is considered payment for the time and effort involved in lending money. The two scenarios are similar in that they keep the economy humming along by promoting lending, borrowing, and spending.

But interest rates fluctuate and vary by loan. Borrowers and lenders benefit from knowing what caused these changes. Rare metals, especially silver, are also affected.

What is an Interest Rate?

The lender charges the borrowers an interest rate when borrowing money. Interest rates are typically expressed as a percentage of the loan principal (so a 10% interest rate would mean $10 in interest is charged for every $100 borrowed).

Loans come with varying interest rates because of the different purposes each loan serves. Mortgages, for instance, typically have higher interest rates than student loans, as borrowers providing a home as collateral for a mortgage are risking a greater financial loss.

Mortgage payments depend on a number of  interest rate factors. The overall cost of a loan is affected by details like the size of the down payment and the length of the loan term.

Where is the Interest Rate used?

Listed below is where the Interest Rate used.

1. Mortgage Loan

A mortgage loan is an agreement between a borrower and a lender. The bank agrees to lend money to buy a house. In return, repay the loan plus interest over a period of years.

The amount of money borrowed depends on several factors including your current financial situation, your ability to afford a monthly payment, and the size of the property you want to purchase.

2. Auto Loan

Auto loans are one of the most common types of personal loans available today. They allow consumers to borrow money against their vehicle, which makes them an attractive option for those who need cash quickly but don’t want to sell their car outright.

The amount borrowed depends on several factors including the type of loan being sought, the value of the vehicle, and the borrower’s credit rating. 

3.Credit Card

A credit card is a bank or financial institution account that lets its holder buy products online without cash. A credit card works like a debit card, but it doesn’t charge interest until after you make a purchase.

Most people use “charge” cards. Charge cards allow more spending than a checking account. Spending limits vary by provider, but the bigger the credit line, the lower the minimum monthly payment.

4. Payday Loan

A payday loan is a short-term cash advance that typically has an APR (Annual Percentage Rate) between 400% and 1,000%. The amount borrowed is usually equal to two weeks’ worth of wages at minimum wage.

Payday loans are not recommended because they carry high interest rates and fees. They are tempting quick access to funds, but remember that these types of loans are designed to trap consumers into a cycle of debt.

5. Student Loan

Student loans are an important part of financing higher education. However, student loans come with their own set of challenges. For example, they are dischargeable in bankruptcy, which means that the borrowers never completely escape them. They carry high interest rates, which adds up quickly.

What is the Purpose of Interest Rate?

The cost of borrowing money is measured in terms of its interest rate. The rate is typically given as a yearly percentage (APR). The APR reveals how much interest is charged per month, but not how much actually owes at the end of the loan duration.

“Principal” is the remaining debt. Principal is calculated by multiplying the entire loan amount by the remaining months. $5,000 loan for 12 months @ 10% APR (APR). They owe $5,000 at year’s end but only receive $500 in interest.

What are the Types of Interest Rates?

The types of Interest are Simple Interest, Accrued Interest, and Compound Interest.

Simple (Regular) Interest

Simple or regular Interest is the amount of Interest due on loan based on the principal loan outstanding.

For example, the loan requires a $60 interest payment per year ($2,000 * 3% = $60) if an individual borrows $2,000 with a 3% annual interest rate.

Accrued Interest

The term “accrual” refers to Interest that is accumulated but is not due to be paid out until later. Interest accrues daily if a loan has a monthly payment schedule (at the end of the month).

A dollar is added to the loan balance daily if interest costs $30 a month, then $1, for a total of $30 due on the last day of the month. The loan has accrued $15 in interest (which must be paid when the principal of $30 is called) on day 15.

Compound Interest

The interest payments fluctuate over time rather than remaining constant when interest is compounded, or “interest on interest,”.

The borrower pays $22 in Interest if a borrower has a balance of $100 in Interest on a $1,000 loan at 2% interest after a year. Applicants earn interest on interest, which means the interest rate rises when interest is compounded.

What is a Good Interest Rate?

A good interest rate is one that permits homeowners to amass sufficient equity to return most of (if not all of) their initial investment upon the home’s sale.

Compare a loan’s APR against other loans available at the same time to determine its interest rate. Two 30-year fixed-rate mortgages are an example. First mortgage APR is 4%, second mortgage APR is 5%. Even if both rates are the same, the lower APR saves more over time.

How does Interest Rate works?

Interest rate is the amount of interest paid per month on an outstanding loan balance. The higher the interest rate, the more expensive the loan will be.

The interest rate charged on a loan is determined by several factors including the length of the loan term, the type of loan (fixed-rate vs variable), and the borrower’s credit rating.

A fixed-rate mortgage has a set interest rate throughout the life of the loan. A variable-rate mortgage allows borrowers to choose their own interest rates at different points during the loan term.

What is the Average Interest Rates on Loans?

The average loan interest rates have been falling gradually beginning with the onset of the financial crisis in 2008. The average interest rate on a 30-year fixed home loan was 4.5% in January 2009, but reduced to 3.4% in June 2012. In July 2013, the average interest rate on a 15-year fixed home loan stood at 2.9%.

Moreover, current average auto loan rates are 5.7%, down from 7.6% in December 2007.

How are Interest Rates Determined?

First, interest rates determine the amount of interest paid on loans. The higher the rate, the more interest will be charged.

Second, the Federal Reserve sets short-term interest rates (the federal funds rate) which affects long term rates such as mortgages and car loans.

Third, longer-term rates are set by private banks and other financial institutions. These include variable mortgage rates, adjustable-rate mortgages, and savings accounts.

Fourth, interest rates are determined by supply and demand. When more people want to borrow money than lenders are willing to lend out, interest rates go up. Conversely, when more people want to borrow than lenders are willing to loan out, interest rates drop.

What Factors affect Interest Rates?

Listed below are seven factors include:

  1. Credit scores. Interest rates are determined in part by credit scores. Customers with better credit ratings are offered more favorable interest rates.

Higher credit scores mean lower interest rates. Creditors want borrowers who repay loans. A borrower with a higher credit score is more likely to make loan repayments on time.

  1. Home location. Home Location affects interest rates because lenders use this factor to determine whether to offer a loan. Lenders generally give a lower interest rate when considering living closer to other applicants.
  2. Home price and loan amount. Financing costs for homebuyers tend to be higher when the loan amount is small or substantial. Applicants need to borrow a total of the home’s purchase price plus the closing charges less the down payment amount.

Knowing the budget is important before beginning to search for a home. First, real estate websites are useful for learning about average costs in the desired areas.

  1. Down payment. Down payment affects interest rates because it reduces the amount of equity available to be lent out. The more equity put into an investment property, the less likely it is to borrow against it.
  2. Loan term. Loans have different repayment schedules based on their terms. Interest rates and total costs for short-term loans are often cheaper, but the monthly payments are greater.

Details matter greatly; the length of the loans and the interest rate determine the exact reduction in Interest to be paid and the increase in monthly payments.

  1. Interest rate type. Interest Rate Type affects interest rates when calculating monthly payments. The type of interest rate used depends on whether to be an adjustable-rate mortgage (ARM) or not.
  2. Loan Type. Loan Type affects interest rates based on the loan term. The longer the loan term, the higher the interest rate is. For example, an auto loan has a shorter term than a home mortgage.

Are Interest Rates on Loans Necessary?

Yes, interest rates on loans are necessary. Interest rates are one of the most important numbers in the economy because they determine how likely people are to borrow money. Borrowing money becomes prohibitively expensive when interest rates are sky-high. When they are low, the price drops significantly.


Personal Finance Writer at Payday Champion

Kathy Jane Buchanan has more than 10 years of experience as an editor and writer. She currently worked as a full-time personal finance writer for PaydayChampion and has contributed work to a range of publications expert on loans. Kathy graduated in 2000 from Iowa State University with degree BSc in Finance.

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