Interest Rates Explained: How Much Do You Owe?

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Back in 1971, when Freddie Mac first surveyed lenders, mortgages with fixed-rates had an interest very high compared to today’s rates. After that, the interest rates have steadily increased from the start of 1974 to 1981. This trend continued for quite some time as lenders want to profit along with inflation during this period. In order to combat this steady rise, the Federal Reserve also increased the federal funds rate.

Eventually, this strategy paid off, and the inflation rate fell back to single digits. This continued through 2012, where the inflation rate was at its lowest in history. 

During the pandemic, the inflation rate started to rise as a lot of people are losing jobs and income. 2021 is quite hard to predict and might also see a huge rise, with interest rates that can be uncertain at best. Thus, we should always aim for the lowest interest rate in all our borrowing transactions.

What is Interest?

Interest is what the borrower will pay for using an asset or the money used to buy said asset. In the case of properties like a car, house, or a piece of land, the lease itself will serve as the contract in which you’ll pay money that includes interest periodically. 

For a bank and direct lender alike, the amount of your interest depends on your credit score. That said, the better your credit score is, the lower your interest will be. 

interest
Interest

In other terms, you will be assessed by risk. The riskier you are for the lender, the higher the interest rate they will put on your repayment terms and vice versa.

See Also : How to Get Quick Money? 15 Super-Fast Ways To Make Money

When Are Interest Rates Applied?

Mostly, interest rates are applied to borrowing transactions. When a person can’t purchase an asset directly, they tend to take out a borrowing transaction, which can be loans. There are many types of loans in the market like auto loans, mortgages, home loans, etc. But why do lenders charge interests?

The extra money you have to pay back the lender is compensated for the loss of money during that time. The lender could have to use the money to invest in certain accounts to generate profit. Since they can’t have profit anymore due to you borrowing money, you have to repay it back in the form of interest. Typically, the money you borrowed is repaid either in installments or in full on the due date. 

Earning Interest

Depositing money in the bank can yield you profit in the form of interest, especially if you’re depositing your money to a savings account. However, if you deposited your money in an account that allows daily spendings, like checking accounts, you won’t earn interest. At least, that is how most banks operate. Take note that some banks still offer interest even in checking accounts.

Why are banks offering you interest? 

Simple. The money you deposited in your account will be used by the bank to offer other people loans or credit cards. Not only that, but the bank could also use your money to make investments, which will also earn you interest. 

The interest rates you earn from the bank is quoted as APY or annual percentage rate, which takes a compounding effect over time in your account. Your APY is typically lower than the quoted APY. However, after compounding, which means you will earn another interest on top of the first interest, you can earn the full APY based on the money you deposited. Generally, for most banks, when you don’t touch the money you deposited for a year, you will have earned the full APY.

Paying Interest

As mentioned earlier, when you borrow money, you will have to pay your lender the cost of borrowing money in the form of interest. The amount of money you have to pay for the interest is typically expressed in a percentage. 

Thus it’s called the interest rate. Often, you will see a quoted number that signifies your APR or annual percentage rate. It’s different from your interest rate since the APR shows how much you are expected to pay every year for the loan, and this also includes other fees. 

Generally, the most favorable loan is one where you will have to pay the lowest interest rate available. This is only applicable to people who have an excellent credit score

If you have a bad credit score, you will have to accept paying a higher interest rates. However, other factors can affect your interest rate, other than your credit score. One of these factors is the policy of the bank you took your loan from. 

However, these policies can be changed according to the Federal Reserve’s benchmark interest rates. Most banks follow the Federal Reserve trend, and thus it will also change your interest rate. If the Federal Reserve lowers down their benchmark on interest rates, you may also see your bank lowering your rate. 

How Do I Calculate My Interest Rate?

Calculating your interest rate is simple as it only requires you to do intermediate math. Or you can use your calculator if it’s too hard for you. In calculating your interest, remember this equation: l/Pt=r.

l – stands for the interest amount you have paid so far in your loan.

P – would serve as your principal amount.

t – is how much time you’ve paid your loan so far.

r – would be your interest rate in decimal form.

find interest
Find interest

Once you substituted all the values, the resulting number would be your interest rate in decimal form. You can just convert that number by multiplying it by 100, and you’d get your interest rate in percentage form. 

Conclusion

You might think it’s unreasonable for lenders and banks to give you an interest rate, but they wouldn’t have any profit out of the transaction if they don’t. If you want to have the lowest interest rate possible in every loan you get, you have to work hard on improving your credit score. Having an excellent score will let you access the best loan products in the market, which will make your financial life much easier.

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