What Is an Interest Rate?
An interest rate is the percentage of a loan that the lender charges per year for giving the borrower the privilege of using the money. For example, to take out a car loan, a dealer might charge you 8 percent of the amount you own on the loan as interest. Alternatively, when you put money in a savings account at a bank, the bank might pay you 2.5 percent per year because you're letting the bank use your money.
Interest Rate Factors
When lenders make loans, they consider a number of factors to determine the interest rate. Some factors, such as the current financial market conditions, the cost for the bank to service your loan and the desire for the bank to make a profit on the loan, are out of your control. However, you do have some control over other factors, including your creditworthiness and the amount and duration of the loan. For example, if you have a stellar credit score, you're generally going to get a lower interest rate than someone who hasn't been as careful with repaying their previous debts.
Impact of Collateral
Sometimes when you take out a loan, you give the lender permission to take a specific asset, known as collateral, if you don't pay back the loan. For example, when you take out a mortgage, the lender requires you to use the home itself as collateral. That way, if you default, the lender can take the home and sell it to get back what you owe on the loan. Loans secured by collateral generally have lower interest rates than unsecured loans because the lender is less likely to lose what it loaned you.
Fixed Versus Adjustable Interest Rates
Different loans have different types of interest rates. Some loans have a fixed interest rate, which means that the interest rate remains the same no matter how the market interest rate changes during the term of the loan. So, if you borrow the money at 6 percent and the market rate jumps to 10 percent, you get to keep paying only 6 percent. But, if it falls to 3 percent, you still have to pay 6 percent. Adjustable rate loans change the interest rate you pay as the market rate changes. This is beneficial if rates fall, because you can take advantage of lower rates without refinancing, but if the market rate increases, your rate will rise, too, says the Consumer Finance Protection Bureau.
How Interest Rates Affect You
When you borrow money, you must budget to make sure you can afford the payments on the loan. When interest rates are low, you can borrow more money and still be able to make the monthly payment. But, if interest rates rise, you may have to reduce the amount you're borrowing to keep the payments affordable. For example, say you want to take out a mortgage of $120,000 over 30 years. If you get a 4.5 percent interest rate, your monthly payment would be $608.02. But, if you get a 6.5 percent interest rate, the monthly payment increases to $758.48.