Why You Need to Know Interest Rates
Interest rates can be both benevolent and malicious creatures. When interest rates are on your side, you have extra money to reach your financial goals faster. On the other hand, if interest rates work against you, this means you will lose money over time.
When it comes to interest rates, what you don't know will hurt you. In this post, we provide an in-depth overview of what interest rates are and how they work so you can leverage them in ways that benefit you.
What Are Interest Rates?
In a lending relationship, there are always two parties — a lender and a borrower. An interest rate is the percentage of a loan that the lender charges to the borrower. The interest rate is essentially a fee that the borrower pays in order to enjoy the privilege of borrowing money.
An interest rate will tell you how much extra money you can expect to earn or pay.
Interest rates are often expressed in annual terms. For example, if you deposit money into a savings account, you will earn an annual percentage yield (APY). If you take out an auto loan, you will pay an annual percentage rate (APR). Interest rates can also vary over time, such as the Federal Reserve's interest rate, which changes with the pace of the economy.
An interest rate will tell you how much extra money you can expect to earn (as a lender) or pay (as a borrower).
Below, we will take a closer look at how this relationship affects your money:
A Closer Look at APY
Annual percentage yield (APY) is the yearly amount of interest you receive from a deposit account, including checking accounts, savings accounts, and certificates of deposit (CDs).
As mentioned earlier, there are always two parties in a lending relationship — a borrower and a lender. When you open a savings account, your bank is actually borrowing your money. Your bank will then use your money to create loans for other customers. These loans allow your bank to earn enormous profits from earned interest.
When you open a savings account, your bank is borrowing your money.
Keep this in mind as you review your deposit accounts, as many banks charge "service fees" — even though your money keeps them in business! For more information on this topic, we discuss bank fees further in 4 Ways Bank Fees Steal Your Wealth & How to Avoid Them.
In addition to fees, be sure to watch out for deposit accounts with low APYs.
If you have a savings account at a traditional bank, you will likely earn around 0.05% APY (which, as of 12/15/2020, is the average APY of savings accounts). However, if you took out a personal loan at this same bank, you would likely pay up to 28% APR! Considering that your traditional bank is only paying you 0.05% APY to borrow money, it is clear that you are getting the raw end of this banking relationship.
Thanks to their low overhead costs, digital banks offer customers better APYs than traditional banks. For example, let's consider the difference between a traditional savings account and digital bank with 0.60% APY:
| After 1 Month | After 6 Months | After 12 Months | |
|---|---|---|---|
| Jennifer 0.05% APY |
$10,000.42 | $10,002.50 | $10,005.00 |
| Michael 0.60% APY |
$10,005.00 | $10,030.04 | $10,060.18 |
In our example above, Jennifer has $10,000 in savings at a traditional bank, which pays her 0.05% APY. After one year, Jennifer earns a total of $5 in interest.
Michael also has $10,000 in savings but deposits his funds at a digital bank, which rewards him with 0.60% APY. With his higher APY, it takes him only 1 month to earn $5, and he earns a total of $60.18 in interest after one year. Because Michael chose a different bank, he earned an extra $55 for the same amount of savings.
To compare interest earnings for your deposit accounts, we have a handy APY calculator here.
A Closer Look at APR
Annual percentage rate (APR) is the amount of interest you pay per year for debt products, such as mortgages, loans, and credit cards. There are two types of APR — a nominal APR and an effective APR.
Nominal APR vs. Effective APR
A nominal APR is the simple, annualized interest rate of a loan. This is the APR that is prominently stated when you receive a new credit card or personal loan. If your aunt Jo loans you $1,000 with a simple annualized rate of 19.99%, you would pay $199.90 in interest each year.
However, don't be fooled! Nominal APRs are not realistic because they do not include compounding interest. Credit cards, for example, compound interest on a daily basis. If you leave an unpaid balance on a credit card, you will end up paying much more interest than the nominal rate.
Let's take a look at what happens if you leave a $1,000 unpaid balance on a 19.99% APR credit card for one year:
| After 1 Month | After 6 Months | After 12 Months | |
|---|---|---|---|
| Starting Balance | $1,000.00 | $1,086.83 | $1,201.04 |
| Interest Charged | $16.79 | $105.09 | $221.21 |
| Ending Balance | $1,016.79 | $1,105.09 | $1,221.21 |
As you can see, an unpaid balance of $1,000 would cost you $221.21 in interest after one year. That's an 11% increase, or $21.31 more than you would pay with a simple 19.99% interest! Therefore, the true rate of your credit card would be 22.12%, not 19.99%.
Whenever you sign up for a new loan or credit card, it's important not to be fooled by the nominal APR. In reality, the true APR that you pay will be much higher because of compounding interest and additional incurred fees.
Don't be fooled! Nominal APRs are unrealistic because they do not include compounding interest.
An effective APR is a more realistic interest rate because — unlike nominal APRs — it includes compounding interest plus additional fees. Thanks to the Truth in Lending Act, the effective APR is always disclosed whenever you take out a home loan. This APR includes the nominal interest rate, discount points, origination fees, and other closing costs.
To estimate how APR will affect your lending costs, check out our handy Mortgage Calculator and Auto Loan Calculator.
Factors That Affect Interest Rates
When shopping for a loan or deposit account, several factors will affect the types of interest rates you receive from banks and creditors. Some factors are outside of your control, such as the stability of the economy, and others are factors you can work on. A clear understanding of these forces will help you optimize your interest rates so you retain more money over time.
Forces Outside of Your Control
Supply and Demand. One factor that affects interest rates is supply and demand. In economics, supply and demand is a basic model that describes how the prices of products are determined.
Essentially, if the amount of people who want a product (demand) is greater than the amount of product that is available (supply), then the price of the product will increase. However, if the demand for a product is less than its supply, the price will decrease.
For a simple analogy of this behavior, consider how retail items typically go on sale when customers are not buying the products. Shop owners will decrease the price of a product to make it more appealing to customers. However, if an item is in high-demand, the shop owner will raise prices.
This phenomenon also applies to interest rates.
Interest rates are the price that you pay to borrow money (or, in the case of APY, the price your bank pays to borrow your money). The money is the product. When the amount of customers who want to borrow money increases, banks and creditors will increase interest rates. On the other hand, if the demand for credit is low, such as during a recession, banks and creditors will lower APR to attract more customers.
If the demand for credit is low, such as during a recession, banks and creditors will lower APR to attract more customers.
Inflation. In addition to supply and demand, interest rates are also affected by inflation. Inflation is the term used to describe when the price of all goods and services increases. For example, annual inflation in the United States is about 2% per year. This means the cost of living — across the entire country — increases every year by 2%.
When inflation occurs, interest rates increase. This is because the value of a dollar (or purchasing power) has also decreased. In other words, today's dollar cannot purchase as many goods and services as yesterday's dollar. Because the value of money has decreased, banks and creditors will increase rates to make up for the loss in monetary value.
Government. The Federal Reserve uses interest rates as a tool to stabilize the economy. When the economy is doing poorly, the Federal Reserve lowers interest rates to encourage borrowing and spending. When the economy is doing well, however, the Federal Reserve raises interest rates to prevent inflation.
(For a more thorough explanation of how the Federal Reserve affects interest rates, Investopedia has an in-depth explanation here.)
Factors You Can Control
Credit Score. Your credit score is a major factor that will affect interest rates when applying for a loan or credit card. Credit scores are an indicator of your creditworthiness — a score above 700 informs banks and creditors that you are likely to make payments on time. However, a credit score below 700 indicates that you are less likely to be a reliable borrower.
When you apply for a loan with a low credit score, creditors will increase interest rates to make up for the added risk. However, if you apply with a high credit score, creditors will decrease interest rates to entice you to borrow money.
When you apply for a loan with a low credit score, creditors will increase your interest rates to make up for the added risk.
Collateral. Like credit scores, collateral also plays a large role in determining interest rates. Collateral is property that a lender can seize in the event that a borrower stops making payments. After seizing the collateral, the lender will sell the borrower's property so they can recoup its losses.
When you apply for a secured loan, such as a mortgage or auto loan, you agree to give the lender some collateral — your lender can seize your house or car if you fail to make payments. Because of this decrease in risk, secured loans have lower interest rates overall.
However, when you apply for an unsecured loan, such as a personal loan or credit card, this means that the lender does not have collateral. There is nothing to seize if you fail to make payments — the lender's only options are to sell your debt to a debt collector or file a lawsuit against you. Because of this added risk, unsecured loans have much higher interest rates than secured loans.
Loan Amount and Duration. When you get a loan, the size and duration of your loan also affect interest rates. This is because larger loan amounts mean longer loan terms, and longer loan terms create more risk. When you get a short-term loan (3 — 18 months), your ability to pay back the loan is unlikely to change during that period. Because of this decrease in risk, shorter loan terms have lower interest rates.
For longer loan terms (3 — 30 years), there is added risk to the creditor. During this period, the economy could tank or you may lose your job — many unknown factors could affect your ability to repay the loan. With this added risk, creditors will increase interest rates for longer loan terms.
Why It's Important to Pay Attention to Rates
If your goal is to have more money, then you must pay attention to interest rates.
As you saw in our previous examples, failure to optimize interest rates will cause you to lose money over time. By settling for low-APY accounts, you will lose money by not earning the extra interest you would receive from high-APY accounts. Likewise, settling for high-APR loans and credit cards will cause you to pay extra, unnecessary interest to your lenders.
Keeping your credit score high and staying aware of economic forces (such as inflation and the Federal Reserve) will help you optimize interest rates. Be careful of complacency — your failure to optimize rates will mean less money for you to enjoy in the long term.
For an overview of Axos Bank's high-yield deposit accounts, take a look at our Personal Banking accounts here.
Why You Need to Know Interest Rates
This blog post was published by Axos Editorial Team on March 15, 2019 and last updated on May 4, 2021.
