An interest rate is both simple and complex. It can work for you or against you, which sometimes makes it hard to understand. Let’s start by defining interest rate, and then, we will break down how it works.
Investopedia defines interest rate as, “the interest rate is the amount a lender charges for the use of assets expressed as a percentage of the principal. The interest rate is typically noted on an annual basis known as the annual percentage rate."
There is a lot of financial lingo in that definition, so to put it simply, interest is the cost of borrowing money. This cost has to be paid back to the lender along with the amount of money borrowed.
A financial institution, such as a credit union or bank, gives money to a person in the form of a loan. Loans are a type of debt. There are many types of loans, but the most common are Mortgage (home loan), Auto Loan, Line of Credit, Student Loan, and Personal Loan.
When a borrower goes to take out a loan they are told the APR, or annual percentage rate, of the loan. The Annual Percentage Rate is the total percentage of interest (the cost of borrowing money) applied per year. To simplify it even more, APR is what the lender charges to borrow money on an annual basis.
Interest Rate and Annual Percentage Rate are similar but act different.
Interest rate is the current calculation of the cost of the loan.
APR is the annual calculation of the cost of the loan that includes any fees or charges that may occur during the average period of time before the debt is repaid. Here are examples of fees that could be included in APR: application and processing fees, legal fees, loan origination fees, underwriting fees, escrow, and insurance.
Some financial institutions will show the borrower both the interest rate and APR that will be calculated on a loan. If both rates are available, the APR may be greater than or equal to the interest rate. Both rates are ways for borrowers to compare lenders and determine the affordability of the loan.
Interest rate gives a short-term view of the cost of a loan, while APR gives a big picture cost of a loan.
Understanding interest rate and APR helps you make better choices when it comes to borrowing money, opening a credit card, and improving your credit score.
APR and interest rate calculated for a credit card differs from the APR and interest rate calculated on a loan.
It is important that the borrower pays their loan payment on time, or if there is extra money available, pay more than the minimum payment. We mentioned earlier, interest can either work for you or against you. If the borrower regularly misses payments or is late on a payment, that increases the interest that is accrued on the loan. With increased interest, it prolongs the life of the loan and costs more in the long run. This is interest working against you.
Don’t forget interest can also work in your favor.
Interest can work in your favor in regards to savings accounts and some checking accounts. Financial Institutions borrow money from their customers or members in the form of deposits. Financial Institutions use the deposits from savings, or sometimes checking accounts, to fund loans. They pay interest rates on savings accounts, and some checking accounts, to encourage people to make deposits. When you put money in a savings account and leave it, it earns interest and increases over time.
When do you want to look for a high interest rate?
High interest rates are great for savings accounts because it means you earn more money for saving with your financial institution. High interest rates on loans on the other hand mean you’ll pay back more over time.
So, when do you want to look for low interest rates?
Low interest rates are great for loans because it means you, the borrower, will owe less. While low interest rates on savings accounts means you, the saver, will earn less dividends for saving with your financial institution.
To put it simply, you want to look for high interest rates on deposit accounts and low interest rates on loans and credit cards.
Hopefully, now you have a better understanding of interest and APR. This is a very basic overview of what interest rate and annual percentage rate are and how they work.
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