What Are Interest Rates?

Interest rates refer to the amount a lender charges a borrower in return for the privilege of borrowing money. This figure is generally expressed as a percentage of the principal. For example, if the interest rate on a $1,000 loan is 5 percent per year, and you want to pay off the loan in full at the end of a year, you would pay $1050: the $1000 you borrowed, plus $50 in interest. When you put money in a deposit account, you're essentially "loaning" money to the bank, so the bank pays you interest.

Effect of Interest Rates

The higher the interest rate, the more interest accrues on the balance of the loan or account. When you're borrowing money, you want the interest rate to be as low as possible so you pay as little interest as possible. However, when you have money in an account earning interest, such as a savings account or certificate of deposit, you want the highest interest rate so that you earn more interest.

How Interest Rates Are Set

Lenders take several factors into account when setting interest rates. Factors include the cost of the bank obtaining the money, including the interest paid to customers on deposit accounts; the costs of servicing the loans, to compensate for the risk that the loan won't be repaid; and the profit on the loan. The interest rate that you get charged also depends on your credit profile, including your credit score, how much you're borrowing and what, if anything, you're using as collateral for the loan.

Fixed Versus Variable Rates

Different types of loans have different types of interest rates, including fixed rates, which stay the same for the duration of the loan, and variable rates, which change periodically as the market interest rate changes. For example, with a fixed rate mortgage, your interest rate stays the same regardless of whether rates go up or down. On the other hand, if you have a variable rate mortgage, your interest rate will go down if the market rate falls, and it will go up if the market rate rises. Some loans offer a combination. For example, a 5/1 adjustable rate mortgage has the same rate for the first five years of the mortgage, and then it is adjusted once a year after that.

Additional Costs of Borrowing Money

Depending on the terms of your loan, interest might not be the only cost you pay to borrow the money. Lenders may charge you fees for creating the loan and other fees over the life of the loan, so make sure you consider those costs. For example, mortgages often list two different rates: the interest rate and the annual percentage rate, or APR. The APR includes the interest expense and other fees associated with a mortgage such as closing costs and discount points.

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