Rising interest rates can quietly increase monthly expenses. In 2022 and 2023, central banks raised interest rates to slow down inflation. For example, the European Central Bank went from 0 to 4.5% in less than two years. By mid-2024, many central banks, including the U.S. Federal Reserve, started lowering rates again, with more cuts expected in 2025 and 2026.
Even with rate cuts underway, this doesn’t mean interest rates will stay low. You must understand how interest rates work to reduce borrowing risks and preserve your savings.
As such, this article will explain interest rates, how to calculate them, when they’re applied, and what can cause them to change.
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Explaining Interest Rates: What Are Interest Rates?
Interest rates represent the cost of borrowing money or the return you earn on savings. The rate depends on the lender, the financial product, and your credit profile.
Explaining Interest Rates: Fixed and Variable Rates
Interest rates are either fixed or variable. A fixed rate stays the same for the entire repayment period, keeping your monthly payments consistent.
Meanwhile, a loan with a variable rate might start with lower payments, but if interest rates rise after a few years, your monthly payments could increase beyond what you initially paid.
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Explaining Interest Rates: Why Do Interest Rates Exist?
Interest rates exist for the following reasons:
Lenders Need to Make Money and Stay Protected
Lenders charge interest to offset the risk of non-repayment. It compensates them for potential losses and provides a return on the money they’ve lent out.
Interest Encourages People to Save or Invest
When you deposit money into a savings account, the bank pays you interest in exchange for holding your funds. It’s their way of rewarding you for saving instead of spending.
Interest Rates Help Keep Things Steady
Higher rates increase the cost of loans, often leading to reduced spending and slower borrowing. However, lower rates make credit more affordable, encouraging consumers and businesses to spend more. These shifts help regulate economic activity.
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Explaining Interest Rates: Who Determines Interest Rates?
Interest rates are set based on central bank policies and adjusted by individual lenders according to market conditions, risk, and loan type.
Central Banks Set the Base Rate
In the US, the Federal Reserve influences interest rates by setting the federal funds rate. While it doesn’t control individual loan rates, changes to this benchmark lead banks to raise or lower rates on credit cards, home loans, and car loans.
Lenders Choose the Rates They Offer
Banks, credit unions, and online lenders set their own rates based on the central bank’s base rate and their internal risk models. They may also adjust rates based on loan type, borrower profile, or funding costs.
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Explaining Interest Rates: When Are Interest Rates Applied?
Interest applies in different situations, depending on how you’ll use the funds. You’ll see it added when you borrow, carry a credit card balance, repay a loan, or earn returns from a savings account.
Interest Starts When You Borrow
Interest starts accumulating when funds are disbursed on loans. Some lenders begin charging interest immediately, while others may offer a brief grace period before it applies.
Carrying a Balance Means Paying More
If you carry a credit card balance past the due date, interest accrues on the unpaid amount. The longer the balance remains, the more interest adds up, raising the total you owe.
It Grows Over Time
Interest is calculated based on how often it’s applied (daily, monthly, or annually), depending on the account or loan type. Daily interest loans grow faster because charges are added more frequently, while monthly or annual schedules result in slower accumulation.
Interest Can Work in Your Favor Too
With a savings account or certificate of deposit (CD), the bank pays you interest for holding your money. These accounts reward you over time, with earnings based on the deposit amount, term length, and interest rate.
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Explaining Interest Rates: Where Are Interest Rates Used?
Below are the banking services where interest rates apply:
When You Borrow Money
Interest is a standard cost when you borrow money. It reflects the lender’s charge for providing access to funds over a set period. Here’s where you’ll typically see it charged:
Personal Loans
Personal loans are often used for home improvements, debt consolidation, medical bills, or emergencies. Your interest rate is based on factors such as your credit score, income, and repayment period. Each monthly payment covers both interest and part of the principal until the loan is paid off.
For instance, if your air conditioner stops working and a replacement costs $4,000, you might finance it with a personal loan at a 7% rate over three years. That interest adds to the total, so you’d repay over $4,000 by the end of the term.
Mortgages
Buying a home typically involves borrowing a substantial amount over a long period. Even a small difference in the mortgage interest rate can affect the total cost of the loan. Fixed-rate mortgages keep the same rate throughout the term, while adjustable-rate mortgages may change based on market conditions.
For example, a $200,000 mortgage at a 5% interest rate over 30 years results in more than $180,000 in interest, assuming regular payments over the full term.
Student Loans
Student loans from federal and private lenders accrue interest, and some begin accumulating while you’re still in school. This means the total amount you owe can increase before repayment even begins.
Let’s say you borrow $15,000 for tuition with a 5% interest rate that accrues immediately. The amount you owe at graduation may be higher than what you originally borrowed, depending on how long the interest has been building.
Auto Loans
Many car buyers finance their purchase instead of paying the full amount upfront. Auto loans include interest, which increases the overall cost beyond the sticker price.
For example, if you finance a $25,000 vehicle at a 6% interest rate over five years, you could pay around $3,999 in interest, bringing the total closer to $29,000 by the end of the loan term.
Credit Cards
When you carry a credit card balance, the issuer applies interest daily, which increases your total cost the longer it remains unpaid. Since credit card rates tend to run higher than other loans, reducing the balance quickly can limit those extra charges.
Suppose you use your credit card to handle a $500 emergency expense and then only make the minimum payments. The interest will continue to accumulate, and over time, you’ll pay back more than the original $500.
Payday Loans
Payday loans are short-term borrowing options designed to cover expenses until your next paycheck. Lenders typically offer them without credit checks, making them accessible during a tight budget period.
However, these loans carry high fees that increase the total cost quickly. For instance, borrowing $400 with a $60 fee means you owe $460 in just two weeks. If you can’t repay it by the due date, the lender may extend the loan and add another fee.
When You Save or Invest
Interest can also benefit you when you allow a bank or credit union to hold your money for a set period. In return, they pay you based on the account type and balance. Below are the services where you earn interest:
High-Yield Savings Accounts
High-yield savings accounts pay more interest than standard ones because online banks can offer better rates without the costs tied to brick-and-mortar branches. These accounts help you earn more on your balance while keeping your money accessible and insured.
For example, a $10,000 deposit in a high-yield account with a 4.00% APY would earn about $400 in interest over 12 months. A traditional account might pay less than a quarter of that.
Certificates of Deposit (CDs)
Certificates of deposit (CDs) are fixed-term accounts where you leave your money untouched for a set period. In exchange, the bank locks in a fixed interest rate for the entire term. Longer terms usually come with higher rates.
Let’s say you have a 12-month CD with a 5.00% APY on a $5,000 deposit. As long as you don’t withdraw early, this amount would earn about $250 in interest by the end of the term.
Bonds and Similar Investments
Bonds are agreements where you provide funds to a company or government, and they repay you with interest. The terms are fixed upfront, including when you’ll get paid and how much. Bonds are commonly used to earn predictable returns without taking on high volatility.
For example, putting $1,000 into a bond with a 3.5 percent rate gives you $35 each year until the bond matures.
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Explaining Interest Rates: How Are Interest Rates Calculated?
Here are some tips for calculating your interest rates:
Use the Interest Formula
You can estimate your potential interest rates with this formula:
Interest = Principal × Rate × Time
Say you borrow $2,000 to buy a refrigerator and agree to repay it over two years at a 6% annual interest rate. To estimate the total interest, multiply the loan amount by the rate and then by the number of years: $2,000 × 0.06 × 2 = $240.
That means you’ll pay $240 in interest, bringing the total repayment to $2,240 over two years.
Compound Interest Adds Up Faster
Compound interest calculates interest on both the current balance and any prior interest added.
In a savings account with monthly compounding, the bank uses your updated balance each month to calculate the next interest payment, which includes the interest from the previous month.
On the borrowing side, a credit card with daily compounding adds interest to your balance daily, making the total grow more rapidly than it would under simple interest.
Check Your Loan or Credit Terms
Always review the terms of your loan or credit card before estimating interest. Check the rate, how it applies, and whether it can change during the repayment period.
For example, a $10,000 car loan with a 4% annual rate over five years may include monthly compounding. That means your total repayment depends on how interest is calculated, not just the advertised rate.
Use Online Calculators
You can use online calculators to estimate interest based on the loan amount, rate, and repayment period. Some tools also show how much interest you save by paying more each month or how different loans compare side by side. In addition, others can break down how compound interest adds up compared to standard interest.
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Explaining Interest Rates: What Affects the Interest Rate You Receive?
Interest rates and fees aren’t fixed across borrowers, even for the same type of loan. Lenders adjust the terms based on how they evaluate each application through the following factors:
Credit Score
Lenders use your credit score to assess how reliably you repay debt. The score reflects past borrowing behavior, such as payment history and current balances. A score above 670 typically signals lower risk, which can qualify you for a lower interest rate.
Income and Employment
Lenders examine your income and employment record to evaluate your ability to repay. A stable income stream from long-term employment reduces the chance of missed payments. Based on that, some lenders can offer you lower rates when you have consistent earnings.
Loan Amount and Term
Lenders take on more risk when the loan amount is high or the repayment stretches over several years. The longer the timeline, the more likely your income or expenses could shift. To manage that uncertainty, lenders may apply a higher interest rate to bigger loans or those with extended terms.
Debt-to-Income Ratio (DTI)
The debt-to-income ratio measures how much your monthly income goes toward debt payments. When that percentage is high, lenders may see it as a sign that you could struggle to acquire new debt. As a result, they may respond with a higher interest rate or decline the application.
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Explaining Interest Rates: Why Do Interest Rates Change Over Time?
Interest rates shift in response to broader financial conditions and policy decisions. As a result, the cost of borrowing or the return on savings doesn’t stay constant.
Inflation Plays a Big Role
When inflation rises, money loses purchasing power. Therefore, central banks may increase rates to slow down spending and reduce economic pressure. This makes borrowing more expensive and saving more attractive. Also, when inflation drops or the economy contracts, lowering rates can make credit more accessible and encourage financial activity.
Central Banks Make Policy Changes
Central banks set benchmark rates that affect how much it costs banks to access short-term funding.
When the Federal Reserve raises its rate, banks respond by increasing rates on loans and credit. As a result, loans and credit lines come with higher interest charges.
However, when the Fed lowers the rate, banks usually reduce lending costs. These adjustments are based on data such as price growth, labor market trends, and economic activity forecasts.
Lenders Respond to the Market
Banks and lenders track what competitors are offering and adjust accordingly. If one cuts rates to drive more loan activity, others might revise their pricing to align with market expectations. Raising rates, on the other hand, can be a deliberate move to limit new lending or shift focus. These changes reflect each institution’s pricing strategy, market position, and risk management approach.
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Final Thoughts
Interest rates determine how much you repay on loans and earn on deposits. Before signing a loan agreement or opening a savings account, check when interest starts, how it applies, and what conditions affect the rate. This way, you can make informed comparisons based on the actual cost or return.
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