Interest rates play an important role in our financial lives, but they can be confusing to understand. The best way to take control of your finances is to understand exactly what an interest rate is, who sets them and how they affect loans, credit cards and savings accounts.
An interest rate is a percentage that represents the cost of debt for borrowers or the return earned on investment for savers. It is calculated by dividing the annual percentage rate (APR) of a loan or investment by its principal amount. APRs can be quoted on a flat sum or on an annual compounded basis. The latter is more common for investments, such as bank savings or term deposits, where a higher APR will be earned from a higher amount of principal.
There are a number of factors that impact the interest rate on a loan, including the type of loan and the borrower’s creditworthiness. For example, mortgage loans are secured by real estate, so they typically have lower interest rates than personal loans or credit cards that aren’t backed by assets. The loan’s duration and whether it is fixed or variable also factor into the interest rate offered.
For those who are not risk-averse, a variable interest rate may be more advantageous than a fixed one. However, comparing loans by their APRs may not be a good idea as it does not take into account fees charged by banks (like annual fees) or inflation. A comparison rate, on the other hand, takes these things into account and provides a more accurate picture of a loan’s true costs.
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