What Is an Interest Rate?
An interest rate is the percentage of the principal charged by a lender to a borrower. This rate is commonly expressed as an annual percentage rate (APR) for loans, while it is known as annual percentage yield (APY) for savings accounts or certificates of deposit (CDs).
Key Takeaways
- The interest rate is a lender’s charge to a borrower for using assets.
- An interest rate applies both to loans and deposit accounts.
- Most mortgages use simple interest; some loans use compound interest.
- Lower-risk borrowers receive lower interest rates compared to high-risk borrowers.
- The APY quantifies the interest earned on deposit accounts using compounded interest.
Understanding these basics can empower you to make better financial decisions.
Understanding Interest Rates
Interest is effectively a fee for borrowing money—often described as the “cost of money.” Loans are typically used for big-ticket items like homes or education, and are paid back either as lump sums or in periodic installments.
Simple Interest Rate Example
If you borrow $300,000 with a 4% simple interest rate over one year, you would repay $300,000 + $12,000 (which is 4% of $300,000) = $312,000. For a 30-year mortgage, the simple interest calculation would be:
$$ \text{Simple Interest} = \text{Principal} \times \text{Interest Rate} \times \text{Time} $$
$$ = 300,000 \times 4% \times 30 = 360,000 $$
This results in $360,000 in interest over the life of the loan.
Compound Interest Rate Example
Compound interest accumulates interest on both the initial principal and the interest that has been added over time. For example, if you have a $10,000 loan at 5% interest compounding annually for three years, the formula for compound interest is as follows:
$$ \text{Compound Interest} = P \times [(1 + r)^n − 1] $$
Where:
- P = principal
- r = interest rate
- n = number of compounding periods
For Ben’s loan with $10,000 principal compounded annually at 5% for three years:
$$ 10,000 \times [(1 + 0.05)^3 − 1] = 10,000 \times [1.157625 − 1] = 1,576.25 $$
Compound Interest and Savings Accounts
Savings accounts and CDs use compound interest favorably. For example, by depositing $500,000 into a high-yield savings account with a 5% interest rate, and assuming the bank loans part of it out at 8%, you not only earn interest but help drive the economy by facilitating loans.
Borrower’s Cost of Debt
Interest rates signify income for lenders and cost for borrowers. Companies consider both debt (incurring interest) and equity (issuing shares) to optimize capital structures.
APR vs. APY
APR is used for consumer loans and doesn’t consider compound interest, unlike APY, which represents compounded interest earnings in savings.
How Are Interest Rates Determined?
Central banks, like the Federal Reserve, play a pivotal role. They adjust rates based on economic conditions. Higher central bank rates generally slow borrowing and demand, while lower rates encourage economic activity. The relationship with inflation means higher interest rates combat rising prices, while lower rates promote spending.
Addressing Disparities in Interest Rates
Despite regulations, systemic biases exist in lending practices. Data shows a disparity in mortgage approvals and interest rates based on racial demographics, with higher interest rates often found in ethnic-minority communities.
Why Are Long-Term Loan Rates Higher?
Long-term loans carry more risk and have higher opportunity costs, leading lenders to demand higher interest rates for these loans.
The Federal Reserve’s Role in the Economy
The Fed controls national interest rates to regulate economic activity. By setting borrowing costs up or down, the Fed influences broader economic behavior, reducing economic overheating or stimulating growth.
Bond Prices and Interest Rates
Bond prices move inversely to interest rates. Higher rates devalue existing bonds since new issues enjoy better returns, while lower rates make existing higher-yield bonds more attractive.
The Bottom Line
Interest rates dictate the cost of borrowing and rewards for lending. Understanding and managing them prudently can elevate your financial health and wealth.
Related Terms: APR, APY, simple interest, compound interest, central bank, Federal Reserve.
References
- Consumer Financial Protection Bureau. “What Is the Difference Between a Loan Interest Rate and the APR?”
- Experian. “What Is Annual Percentage Yield (APY)”?
- Experian. “What Is an APR?”
- Federal Reserve Board. “Federal Open Market Committee: About the FOMC”.
- Freddie Mac. “30-Year Fixed-Rate Mortgages Since 1971”.
- Consumer Financial Protection Bureau. “Summary of 2022 Data on Mortgage Lending”.
- Realtor.com. “The Surprising Ways Race Remains a Factor in Mortgage Lending”.
- Harvard Joint Center for Housing Studies. “HIGH-INCOME BLACK HOMEOWNERS RECEIVE HIGHER INTEREST RATES THAN LOW-INCOME WHITE HOMEOWNERS”.
- Housing Matters - Urban Institute. “Homeownership Is Much More Costly for Black Homeowners”.
- Oxford Academic. “The Review of Financial Studies: Do Minorities Pay More for Mortgages?”
- Federal Reserve Board. “Finance and Economics Discussion Series: How Much Does Racial Bias Affect Mortgage Lending? Evidence from Human and Algorithmic Credit Decisions”.
- U.S. Securities and Exchange Commission, Investor.gov. “Bonds”.
