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Interest Rates: What They Are and The Basics

October 6, 2020

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Interest rates are the cost of borrowing. 

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

Each loan comes with risk that the lender won’t be paid back. 

If the lender considers the risk high, they’ll charge higher interest, which means more you’ll have to pay to borrow

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. 

This guide will walk you through the basics and how they come into play with your finances.

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 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 a rate you get on personal loan depends on the Fed rate.

Interest rate vs APR

Interest rates and APRs are similar, but they have a few important differences.

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 the 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. 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 during the loan. So the interest rate you start out with might be very different than 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. 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 stake up something valuable (known as collateral) to secure the loan. If you can’t pay the loan back, the lender can take the collateral.

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

Credit card interest rates

Credit cards also have APR. 

A credit card APR is the 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, the money you used is like a small loan. Unless you pay it back usually within a few weeks, it will draw interest.

Credit cards can come with fixed interest rates or variable interest rates.

Savings account interest rates

Remember, an interest rate is the cost of borrowing. 

If you leave your money in a savings account, it will draw interest because a bank uses the money in your savings account for loans to other people. 

That means the bank is borrowing your money to loan to others, so the bank pays you interest.

The interest rates for savings accounts are usually low. T

There are also high-yields savings accounts that have higher interest rates, which means more money for you. 

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, and other debt to decide if you’re trustworthy for lending.

More trustworthy they find you, the lower the risk for them and the lower your interest rate.

If you’re in the market for a new personal loan or credit card, make sure to check out at a few options. Look at the interest rate or APR that comes with each option and choose the one that will fit your lifestyle. 

Opinions, advice, services, or other information or content expressed or contributed here by customers, users, or others, are those of the respective author(s) or contributor(s) and do not necessarily state or reflect those of Varo Bank, N.A. Member FDIC (“Bank”).. Bank is not responsible for the accuracy of any content provided by author(s) or contributor(s).
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Julian Dossett

Julian Dossett

Julian is a tech and finance writer, covering stories from artificial intelligence and cryptocurrency to personal loans and credit cards. His work has appeared at The Simple Dollar, Bankrate, and Blockchain Beach. As a former Cision editor, Julian worked across the table from many of the nation’s most trusted brands. He’s currently based in New Mexico.

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