What is an interest rate and how can I lower it?

Over the course of your financial future, interest rates will most likely be a factor. Whether it’s a mortgage, an auto or a student loan, a credit card, or a personal loan, most of us will have to borrow money at some point and take into account interest rates.

Interest rates are the price you pay to borrow money. When a lender agrees to loan you money, they expect to be paid back and make a profit. Interest rates determine how much the lender will make off of the loaned money.

Each loan comes with the risk that the lender won’t be paid back, or at the very least, on time. If the lender considers the risk high, they’ll charge higher interest to account for this risk, which means you’ll have to pay more to borrow. There are sometimes exceptions, such as when you get a promotional 0% interest rate or when you have a credit card but continuously pay the balance in full each month.

Different loans have different rates, and the rates can change over the life of the loan. So smart borrowing requires a bit of know-how to navigate the sometimes confusing world of interest rates. Here, we’ll walk through the basics, how they come into play with your finances, and what you can potentially do to lower your interest rates.

Who sets interest rates?

The Federal Reserve or “Fed” is the United States’ central bank. The Fed sets the federal funds rate, which is the interest rate that banks use to charge each other interest for overnight loans.

The federal funds rate also guides other interest rates. If the federal funds rate is low, then interest rates are low, so borrowing is less expensive. If the federal funds rate is high, then interest rates are usually high, so borrowing becomes more expensive.

How good of a rate you get on a loan depends on the Fed rate, as well as other factors like your credit score, your lending history, and your debt-to-income ratio.

Interest rate vs. APR

Interest rates and APRs are similar, but there are a few important distinctions between the two.

An interest rate is a percentage of the total dollar amount that’s loaned to you. You’ll have to pay back the amount you borrowed, but you’ll also have to pay back a percentage of that amount, which is the loan’s interest.

So if you borrow $100 dollars at 5% annual interest, at the end of the loan you’ll owe $105.

An Annual Percentage Rate (APR) is an interest rate, plus a few other fees. The fees included in APRs are usually application fees, processing fees, and legal fees, but there may be other fees as well.

Fixed rate vs. variable rate

Interest rates and APRs can be roughly divided into two main categories—fixed rates and variable rates.

A fixed interest rate is determined at the beginning of the loan and this rate stays the same over the life of the loan. Because you know the amount of interest you’ll pay at the beginning of the loan, fixed-rate loans are often considered a safer option to variable-rate loans.

A variable interest rate can change over the duration of the loan. So, the interest rate you start out with might be very different from the one you end up with at the end of the loan.

Variable interest rates are usually tied to an index, such as the prime rate.

Personal loans

There are many different types of personal loans, and the type of loan you take out can affect the interest rate.

Some loans are for specific purposes, like mortgage or car loans. Other personal loans are for general purposes, and can be used for anything.

Personal loans are either secured or unsecured. Secured loans require you to offer up something valuable (known as collateral) to secure the loan. If you can’t pay the loan back, the lender can then collect this collateral.

Secured loans are considered lower risk, and often come with lower interest rates than unsecured loans.

Credit card interest rates

Given that most of us have credit cards, you’re probably aware that they also have an APR. A credit card’s APR is its interest rate, plus other card fees.

Unlike personal loans, credit cards can carry different levels of debt every month based on how much you charge to the card. Whenever you use your credit card to pay for something, the money you used is essentially like a small loan. Unless you pay it back in full within a few weeks, it will accumulate interest.

Credit cards can come with fixed interest rates or variable interest rates, so before signing up for a new credit card, it’s always important to read the fine print and determine whether your rate is fixed or variable, as well as determine what the APR is.

Savings account interest rates

Like we said before, an interest rate is the cost of borrowing. If you keep your money in a savings account, it will draw interest because the bank uses the money in your savings account to operate and provide loans to other people.

That means the bank is borrowing your money to loan to others, so the bank, in turn, pays you interest. The more you keep in a savings account, the more money you’ll earn from interest.

Interest rates for savings accounts are usually low, but there are also high-yield savings accounts that have higher interest rates, which translates to more money for you.

If you’re ready to start achieving your savings goals faster while earning money on what you save, the Varo Savings Account offers a sky-high starting 3.00% Annual Percentage Yield (APY)¹. That’s one of the highest savings rates in the country relative to most big banks².

What decides my loan’s interest rate?

Aside from Fed guidelines, there are a few other factors that decide your loan interest rates.

Lenders can look at your credit score, personal income, other debt, and debt-to-income ratio to decide if you’re trustworthy for lending, as well as determine the level of risk you present to them as a borrower.

The more trustworthy they find you and the better your credit score and lending history, the lower the risk for them and, in turn, the lower your interest rate.

If you’re in the market for a new personal loan or credit card, always make sure to research several options, as terms and rates can vary greatly from lender to lender. After considering your budget, take a close look at the interest rate or APR that comes with each option and select the one that best fits your finances and your lifestyle.

How can I reduce my interest rate?

Keeping a large balance on a loan or credit card with a high interest rate can get costly. Fortunately, it’s sometimes possible to reduce your interest rate in order to both pay less each month, as well as pay less in the long run.

Keep in mind that even a minor percentage difference can affect the overall amount you have to pay on a loan and that a lower interest rate can cost you much less when looking at the life of the loan.

Here are some of the ways to reduce your interest rate.

Improve your credit score

Improving your credit score is key if you want to take out a new loan or credit card with a lower interest rate, or if you want to request a lower rate for a current loan or card. As we said before, the better your credit score, the less of a risk you present to lenders, which can enable them to offer you a lower interest rate.

Ask for a lower rate from the lender

Sometimes, you can submit a request that the bank or card issuer lowers your interest rate. While they are not required to lower it, they may be willing to, especially if you have a solid history of on-time payments, if your credit score has improved since you originally took out the loan or card, or if you’re perceived as less of a lending risk than you were before based on your debt-to-income ratio.

Consider a balance transfer

If you have a credit card balance that you can’t pay in full over the next few months, you may want to consider a balance transfer if a few extra months will help you get it to $0. But, proceed carefully—balance transfers often have transfer fees and high APRs once the promotional offer expires.

For example, you may be able to get a card with 0% APR on balance transfers for the first 18 months. You could transfer other credit card debt to this card, and then pay off the balance over time without having to pay any interest. Some cards also let you “transfer” available balances into a checking account, which you can use to pay off other loans.

Balance transfer credit cards can be risky, though. If you don’t pay off the debt before the end of the promotional period, you may wind up carrying a balance that has a higher interest rate than you’re currently paying. You may also not get approved for a high enough credit limit to transfer much of your debt.

Consolidate your debt

Consolidating your debt can make it easier to manage your payments and potentially save you money in the long run by lowering your interest rate and the terms of your finance.

Generally, it’s easiest to consolidate debts using an unsecured loan, such as a personal loan. Using a single new loan to pay off multiple loans will leave you with fewer payments to make each month, helping simplify your finances. For example, you might take a $10,000 personal loan and pay off three smaller debts with that sum.

Again, whether or not this makes financial sense to you will depend on the terms and interest rate of the loan you’re using to consolidate debt. Although it may simplify your finances by combining your debts into one payment, there’s no guarantee that it will be at a lower interest rate than you were paying before.

Refinance the loan

You may also be able to refinance debt to lower your interest rate or decrease your monthly payments. Similar to consolidation, when you refinance a loan, you’re taking out a new loan to replace your current loan. However, refinancing can also mean changing the rate and length of your loan.

Generally, you use the same type of loan when refinancing, e.g., you apply for a new auto loan to refinance your existing auto loan, or a new mortgage to replace your existing mortgage. You can also refinance student loans, swapping out old student loans (government and/or private loans) with a new private student loan.

Refinancing can be especially appealing if your credit has improved since you took out the original loan. Perhaps you now earn more money, have less debt, or have an improved credit score—all or any of these things can help you qualify for more favorable terms when refinancing. You’re not the only factor here though, as current market rates can also determine the rate you’re offered during refinancing.

If you’re struggling to afford your monthly payments, you can also consider exploring a new loan with a longer term. While this may lower your overall monthly payment amount, it may also increase how much interest you wind up paying over the life of the loan.

It’s important to keep interest rates top of mind both before you borrow and when you’re in the process of repayment. If you qualify for a lower interest rate than you're currently paying, you can save on interest each month and put those savings toward paying off your loans sooner.