Table of Contents
- What Is an Interest Rate?
- Understanding Interest Rates
- Simple Interest Rate
- Compound Interest Rate
- Compound Interest and Savings Accounts
- APR vs. APY
- How Are Interest Rates Determined?
- Interest Rates and Race
- Why Are Interest Rates on 30-year Loans Higher than on 15-year Loans?
- How Does the Fed Use Interest Rates?
- Why Do Bond Prices React Inversely to Interest Rate Changes?
- The Bottom Line
What Is an Interest Rate?
Let me tell you directly: an interest rate is the price you pay for borrowing money or what you charge for lending it, always expressed as a percentage.
In a loan, it's the percentage of interest based on the principal amount. That's what lenders charge you as a borrower or what you earn from deposit accounts.
For loans, we usually note the interest rate annually as the annual percentage rate, or APR.
Interest rates also apply to savings accounts or certificates of deposit (CDs). Here, a bank or credit union pays you a percentage of your deposited funds. We call the interest earned on these the annual percentage yield, or APY.
Key Takeaways
- An interest rate also applies to the amount you earn at a bank or credit union from a deposit account.
- Most mortgages use simple interest, but some loans use compound interest, which applies to the principal and also to accumulated interest from previous periods.
- If a lender sees a loan as low-risk, you'll get a lower interest rate; high-risk loans come with higher rates.
- The APY is the interest rate you earn from a savings account or CD at a bank or credit union, and these use compound interest.
Understanding Interest Rates
In lending, interest is what you, as the borrower, pay for using an asset. This could be cash, consumer goods, vehicles, or property. Think of the interest rate as the 'cost of money'—higher rates make borrowing that same amount more expensive for you.
Interest rates apply to most lending or borrowing you do. You might borrow to buy a home, fund a project, start a business, or pay for college. Businesses borrow for capital projects, expanding by buying land, buildings, or machinery. You repay borrowed money either in a lump sum by a set date or in periodic installments.
For loans, the interest rate applies to the principal, the loan amount. It's your cost of debt as the borrower and the lender's rate of return. The repayment is more than what you borrowed because lenders want compensation for not using that money elsewhere—they could have invested it and earned income. The interest is the difference between total repayment and the original loan.
When the lender views the loan as low risk, you get charged a lower interest rate. For high-risk loans, expect a higher rate.
Risk gets assessed by looking at your credit score as a potential borrower, so keep yours excellent if you want the best loans.
Simple Interest Rate
Suppose you take out a $300,000 loan at 4% simple interest. You'll pay back the original $300,000 plus (4% x $300,000) = $12,000, totaling $312,000.
We calculate this using the annual simple interest formula: simple interest = principal x interest rate x time.
For a one-year loan, you'd pay $12,000 in interest at year's end. For a 30-year mortgage, it's $300,000 x 4% x 30 = $360,000 in total interest.
That 4% annual rate means $12,000 per year in interest, so over 30 years, that's $360,000.
Compound Interest Rate
Some lenders use compound interest, where you pay interest on the principal and on accumulated interest from previous periods—it's interest on interest.
At the end of year one, you owe principal plus that year's interest. By year two, it's principal plus year-one interest plus interest on that year-one interest.
Compounding makes the interest higher than simple interest. It's charged monthly on the principal plus accrued interest. For short terms, calculations are similar, but longer terms show bigger differences.
Using the $300,000 loan at 4% over 30 years with compounding, total interest owed is nearly $673,019.
The formula is: compound interest = p x [(1 + interest rate)^n − 1], where p is principal and n is compounding periods.
Take another example: a three-year $10,000 loan at 5% compounding annually. You pay $1,576.25 in interest: $10,000 [(1 + 0.05)^3 – 1] = $1,576.25.
Compound Interest and Savings Accounts
When you save in a savings account, compound interest works in your favor. The interest compounds, compensating you for letting the bank use your funds.
If you deposit $500,000 in a high-yield account, the bank might use $300,000 for a mortgage loan. They pay you 5% annually, while charging the borrower 8%, netting 3%. Essentially, you're lending to the bank, which lends to others for interest.
APR vs. APY
Consumer loans quote interest as the annual percentage rate (APR), the return lenders demand for lending money. Credit cards use APR; in our example, 4% is the mortgage APR, not accounting for compounding.
APY is what you earn from savings or CDs, and it does include compounding.
How Are Interest Rates Determined?
Banks determine rates based on the economy's state. The central bank, like the Federal Reserve, sets rates that banks use for their APR ranges. High central rates raise debt costs, discouraging borrowing and slowing demand. Rates rise with inflation.
In high-rate economies, businesses face limited debt funding, leading to contraction.
Low rates stimulate economies: borrowing is cheap, encouraging spending and riskier investments like stocks, fueling expansion. But low rates can cause inflation by creating market disequilibrium, per Walras' law.
Interest Rates and Race
Evidence shows white people get mortgage approvals more often. In 2023, denial rates were 17.1% for Black, 12.1% for Hispanic, 9.7% for Asian, and 6.8% for white applicants.
Studies from Harvard and the Urban Institute confirm Black homeowners pay about 33 basis points more in interest, or $250 extra yearly.
Not everyone agrees—a Federal Reserve study found no preferential treatment, suggesting disparities come from choosing higher rates for lower up-front costs. They note improvements due to automated underwriting and enforcement of fair housing laws.
Why Are Interest Rates on 30-year Loans Higher than on 15-year Loans?
Rates reflect default risk and opportunity cost. Longer loans are riskier with more time for default, and opportunity cost is higher as principal is tied up longer.
How Does the Fed Use Interest Rates?
The Federal Reserve uses rates as a monetary policy tool. Raising borrowing costs for banks influences other rates, making borrowing expensive to cool a hot economy. Lowering rates eases borrowing, stimulating spending and investment.
Why Do Bond Prices React Inversely to Interest Rate Changes?
Bonds pay fixed interest. If rates rise from 5% to 10%, new bonds pay more, so old ones sell at discounts. If rates drop to 1%, old bonds paying more become valuable, bidding up prices.
The Bottom Line
An interest rate is your cost of debt as a borrower and the lender's return. When you borrow, pay extra as compensation. When you deposit, the bank rewards you for using your money to lend to others. These are applied at specified rates.
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