If you’re taking out a loan to extend your home, getting a mortgage, leasing a car, or adding to your savings account, you need to know about interest rates.
Interest is important whenever an asset is lent or borrowed. If you borrow money to buy a new home, you’ll pay interest. But if you lock your money away with a CD from your bank or credit union, you’ll earn interest in return.
This guide walks through how interest works, and easy ways to understand the interest, APR or APY that may apply to your transaction.
What is an interest rate?
Interest is the amount given on top of the principal when an asset is borrowed. You’ll pay interest when you take out a mortgage for example, and you may earn interest if you hold money in savings with your bank.
Interest can be charged on loans and savings, and also on other sorts of assets like vehicles. If you lease a car for example, you’re effectively paying interest in the form of the leasing rate. At the end of the lease agreement, you’ll give the principal – in this case, the car – back to the provider.
Most interest on credit cards, mortgages and loans is presented as an annual figure – an APR or annual percentage rate. This interest rate does not compound, making it relatively simple to calculate the costs of normal consumer loans.
Interest earned on savings is normally expressed as an APY – annual percentage yield. In this case, interest compounds. At first you earn interest on the principle only. But then, once interest is paid into your account, you’ll start to earn further interest on both the principle and the interest already paid. This leads to a steeper curve in your earnings.
What is the current interest rate?
Interest rates are set by banks, credit unions and other financial organizations. They depend on the type of financial product you’re interested in, as well as your credit rating. The interest rate on your credit card, for example, is going to be different to the interest rate you’d be offered on a normal mortgage, or the rate of return on your savings account.
To give an example, at the time of writing, Bank of America offers a range of interest rates on a USD200,000 mortgage which runs from an APR of 2.937% to 2.443%. Rates vary depending on whether you want a fixed rate or variable mortgage, and how long you want to spend paying it back.
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Interest rate calculator
There are a number of useful online tools to help you calculate interest. For example, if you’re saving, the US Securities & Exchange Commission has a helpful compound interest calculator which makes it far easier to see how your interest earnings will add up over time.
If you’re taking a mortgage or other form of loan, you’ll often find that providers have an interest rate calculator which helps to break down the costs involved. There are also plenty of other unaffiliated calculator tools out there, so take some time to research and find the one which suits your needs.
Interest rate vs APR
An interest rate for a mortgage or consumer loan may be expressed as both an interest rate and an APR. The APR may be slightly higher than the quoted interest rate as it includes the interest to be repaid, as well as any applicable fees.
In the case of a mortgage for example, the APR may include closing costs, origination fees and any insurance required. Lenders are required to show the APR so consumers can more easily compare one loan product to another, and get the best available deal.
How to calculate APR vs interest rate
An APR is calculated by taking all of the fees which must be paid, and adding them to the loan principal, before recalculating the interest amount using the applicable interest rate.
However, it’s good to know that the Federal Truth in Lending Act means that consumer lenders must publish the APR as well as the interest rate of any loan or mortgage they offer. That should make it easier to compare one against another in real terms, including all fees.
Getting a great interest rate on a loan or savings account can make a big difference to your overall financial health and wellbeing. Use the information in this guide to help you compare your options when you look at mortgages, loans, CDs and savings accounts, so you know you’re getting the best available deal for your needs.