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Sunday, June 23, 2024

What is an interest rate?

What is an interest rate?

02.28.2024

What is an interest rate?

Interest rates play critical roles in personal and business finances. They govern how much your debt costs and how much you can earn from certain types of investments. Understanding how interest rates work can help you make better financial decisions and manage your money.

Defining the term “interest rate”

Interest rate refers to the amount charged by a lender. When you borrow money from a bank or other lender, interest is the primary method by which the lender earns income. It's the amount you pay back on top of what you borrow and is calculated as a percentage of what you owe.

When you invest in a bond, you're effectively lending your money and you may earn interest on your investment.  When the bond reaches maturity, the bond principal amount may be paid back. 

How do interest rates work?

Interest is essentially a charge to the borrower for the use of an asset, such as cash, property, or a vehicle. When an interest rate is higher, it makes the cost of borrowing more expensive.

If you borrow money, you must pay back the principal amount, as well as the amount you agreed to in interest. Let’s take a look at an example borrowing scenario, assuming a one-year lending agreement:

Jane takes out a $200,000 loan from the bank and the loan agreement stipulates that the simple interest rate on the loan is 4%. This means that Jane will have to pay back the original loan amount ($200,000) plus 4% of the amount she borrowed ($8000). In total, Jane will pay the bank $208,000.

This example was calculated using the simple interest rate calculation:

Simple interest rate = principal x interest rate x time

If Jane’s loan was on a 30-year mortgage, the interest payment would be:

$200,000 (the principal, or the original amount borrowed) x 4% (the simple interest rate) x 30 (the years) = $240,000 (in interest payments)

If you invest money, you expect to receive the amount you put in plus the interest agreed to. Note that with investments, you're not always guaranteed a return, and depending on the type of investment, interest rates may fluctuate. 

Understanding interest rates and paying attention to them can help you estimate or calculate important investment factors such as potential dividend yield or opportunity costs.

Read more: Taking stock: A look at how Americans are investing

Types of interest rates

Exactly how interest is calculated depends on the type of interest rate you're dealing with. Below are the formulas and further explanations for the two most common interest rates.

Simple interest rate

Simple interest is a straightforward method for calculating interest that only applies the interest rate to the principal and not any additional amounts owed or earned. 

The formula for simple interest is:

principal amount x interest rate x time 

It's important to remember that percentages should be expressed as decimal figures for this formula. You can do that by dividing your percentage rate by 100.

For example, say you borrow $1,000 for a period of 1 year at a rate of 5%. You divide 5% by 100 to get 0.05, which is the figure that can be used in the formula. The math then looks like this:

$1,000 x 0.05 x 1 = $50

In this case, you would pay back $1,050 total. If this were an investment, you would earn $50 from it after 1 year.

What if you were borrowing for 5 years? The math would be $1,000 x 0.05 x 5 = $250. Even though the rate is the same, taking longer to pay the loan back results in more money paid in interest.

In the real financial world, interest rates are typically calculated with somewhat more complex formulas, but this gives you an idea of how simple interest works. Simple interest generates less interest than compounding interest, making it attractive if you're borrowing money and less favorable if you invest money.

Compound interest rate

Compounding interest takes into account more than the principal. It is calculated based on the principal plus the interest that has accrued. 

The formula for compound interest is:

[p (1 + r/n)nt]

In this formula:

  • p = principal
  • r = interest rate expressed as a decimal
  • n = how often the interest rate is compounded annually
  • t = the total length of the term

Let's apply this formula to the example above involving $1,000 borrowed at 5% for 5 years. Let's assume the interest is compounded each month, so 12 times a year.

$1,000 (1 + 0.05/12) 5 x 12

$1,000 (1 + 0.004167) 60

$1,000 (1.004167) 60

$1,000 (1.28338)

$1,273.38

Now you subtract the original principal of $1,000, and you find that the total interest paid is $273.38. Compare this with the simple interest figure from the above section of $250, and you'll see that compounding interest results in more interest paid. That's good for you as an investor and typically bad for you as a borrower. 

How are interest rates determined?

Interest rates, or APRs, are determined based on a variety of factors:

  • Inflation and the overall state of the markets and economies. Inflation and the economy impact interest rates in a few ways. The Federal Reserve (Fed) may raise or lower interest rates to attempt to control inflation and other market forces to keep the economy healthy. Often, banks set rates based on something called the "prime rate," which is set by the Fed. 
  • Your personal credit. Your credit history impacts the interest rates banks are willing to offer when you apply for credit. A better credit score typically allows you to get better interest rates because the lender sees you as a lower risk than someone with a poor credit score. Lenders may charge a higher interest rate, so they get more money upfront when someone doesn't have a good credit history. This helps them mitigate losses should the person fail to pay the debt as agreed.
  • The type of debt. When a loan is secured by something other than the person's or business's promise to pay, interest rates may be lower because there's less risk involved. For example, when a bank provides a mortgage loan, it has the option to foreclose on the property and sell it to reduce losses if the mortgage holder stops paying. For that reason, mortgage loans typically come with lower interest than personal loans or credit card debts that aren't secured by collateral.
  • The type of investment. The same is true with investments. Typically, the lower the risk, the lower the potential interest rates you can earn. For example, a Certificate of Deposit investment is one of the most low-risk options, but you typically won't earn a huge rate of return. However, if you take a chance on an up-and-coming company, you could see a return if the company takes off. On the other hand, if the company doesn't do well, you may lose money.

Read more: What debt should I pay off first?

Importance of interest rates

If you pay any attention to financial or economic news, you'll hear a lot about interest rates. You'll hear about them going up, going down and holding steady. You'll also hear or read op-eds on what the Fed should do about rates and when the time to act is (or is not). If you talk about finances with your peers, you may hear what rates they pay on their mortgage or what rate they want if they're looking to refinance. You may discuss the rates paid on savings accounts and other investments.  

There's a good reason that interest rates are the topic of so many financial discussions: They're critically important to the economy and to each individual's personal financial situation. The Consumer Financial Protection Bureau and other agencies are working to ensure a more inclusive financial system,1 including protecting individual rights to fair credit activity and prohibiting discrimination in lending and investing.

Overall, the state of interest rates in the economy can make it easier or harder to get credit or make money on investments. They can impact the buying power of every dollar in your bank account. They substantially affect how much money you need to put away today to save a certain amount for your retirement. Your interest rate can save or lose you thousands — or even tens of thousands — of dollars over the life of a large loan such as a mortgage.

Read more: Mortgage rates and the housing market

Our take

Figuring out interest involves a lot of complex math. Don't let that scare you away from staying informed — especially since you don't have to do that math yourself. When you borrow money, your lender may provide an interest rate calculator or calculation sheet for your consideration. You can also find mortgage loan, car loan, student loan and credit card interest calculators online. Use them to explore various hypothetical situations to understand how interest may impact the cost of your debt.

If you're ready to dive into investments, consider using Empower’s free financial tools, which allow you to analyze your investments, budget month-to-month, and plan for your long-term financial goals.

1 Consumer Financial Protection Bureau, "The Bureau is taking action to build a more inclusive financial system," July 2020.

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Andrew Hefner, CFM

Contributor

Andrew Hefner is a Senior Financial Professional at Empower. A Certified Financial Manager (CFM®), he is responsible for leveraging the technology at Empower to deliver holistic financial planning to help our clients lead better financial lives. 

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. No part of this blog, nor the links contained therein is a solicitation or offer to sell securities. Compensation for freelance contributions not to exceed $1,250. Third-party data is obtained from sources believed to be reliable; however, Empower cannot guarantee the accuracy, timeliness, completeness or fitness of this data for any particular purpose. Third-party links are provided solely as a convenience and do not imply an affiliation, endorsement or approval by Empower of the contents on such third-party websites.

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