JoshUnless you’re a mathematician or a banker, interest rates—despite the name—aren’t actually that interesting. Which is why a lot of people struggle to understand exactly how interest rates work.
Whether you’re trying to calculate your credit card debt, meet with a bank representative about refinancing your mortgage, or applying for payday loans online, having at least a general understanding of how interest rates work could make all the difference between talking yourself into a good deal or a bad one.
The Basics
Among the most commonly used terms which everyone should know are Principal, Interest Rate, and Capitalization. The Principal is the amount of money a lender initially provides to a borrower. The Interest Rate, which is what this article is all about, is an amount expressed as a percentage of the Principal which the lender charges a borrower as a fee for that initial loan. In other words, it is the price one pays in order to borrow money.
A portion of this interest is repaid, along with the Principal, at each previously agreed-upon billing date. When a borrower misses or delays a scheduled repayment, though, interest continues to accumulate. The unpaid interest is then added to the Principal, a process called Capitalization. The more a borrower misses their repayments, the more Capitalization causes the amount they owe to grow.
Types of Interest
Reserved for borrowers with exceptionally good credit, a commercial bank’s Prime Rate is a daily-changing rate that fluctuates based on federal bank rates, inflation, consumer spending, and credit/liquidity issues, among other factors. Although not the rate most borrowers’ loan terms are directly based on, the Prime Rate nevertheless impacts all other types of interest, making it worth paying attention to. When the Prime Rate is high, all other interest rates will be higher. When the Prime Rate is low, all other interest rates will be lower.
One type of interest that the average borrower is almost sure to encounter is a Fixed Rate. A Fixed Rate is, as the name implies, a percentage that, once agreed upon, never changes. It will never go up or go down, giving both lenders and borrowers a sense of stability which makes it easier to plan ahead. In direct contrast, a Variable Rate is an interest percentage subject to change as the market rises and falls over time. The bad news is that a Variable Rate can cause a borrower to pay much more interest on a loan than previously expected. The good news is that, if interest rates decline, a borrower could end up paying much less.
Finally, Annual Percentage Rate, or APR, is a number reflecting the total yearly cost of a loan to the borrower. This includes all expected interest, as well as other associated fees. It is therefore not an alternative to Fixed or Variable Rate interest, but rather a summary of those rates’ effects. If a borrower wants the clearest picture of what their financial responsibilities are in any loan agreement, APR provides the best insight.