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What Are Interest Rates?

Written by MasterClass

Last updated: Nov 8, 2020 • 6 min read

Interest rates are an essential part of the financial system. But do you know how they work? And what they apply to? Here’s a top-down look at interest rates to help everyone become a more financially literate (and savvy!) consumer.

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What Is the Definition of Interest Rate?

An interest rate is the percentage a lender charges on the amount of money borrowed from them. Essentially, interest rates are the cost of borrowing money. When a person, bank, or other financial institution like credit union loans out money, they usually expect to be compensated for the loss of the money over the period of the loan. That’s because they could use that money for something else, like making purchases of their own or investing it in order to make more money. That compensation is called interest and the interest rate is how much is due per period of the loan.

Banks can also pay people and businesses interest, in exchange for keeping their money in savings accounts.

How Do Interest Rates Work?

The interest rate is applied to the principal of the loan, which is the total amount of the loan at the beginning of the loan period. The lender and the borrower agree on a percentage fee, usually on an annual basis, that’s called the annual percentage rate (APR). If a borrower is considered high risk—like, for example, if they have a poor credit rating—then the interest rate may be higher than it would be for a lower risk borrower.

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Real World Applications of Interest Rates

Interest rates apply to a range of common financial instruments. These include:

  • Mortgage rates
  • Car loans
  • Business loans
  • Personal loans
  • Certificates of deposit (CD)
  • I bonds
  • VA loans
  • Student loans
  • Credit cards

Each financial instrument—and each agreement with the bank or other lender—will have its own interest rates.

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Compound vs. Simple Interest

There are two types of interest:

1) Simple

What Is the Definition of Simple Interest?

Simple interest is paid exclusively based on the principal amount.

What Is the Formula for Simple Interest?

The formula for simple interest is: Principal x Interest Rate x Time

So, for example, if someone took out a loan of $100,000 at a 15% interest rate over five years, the calculation would look like this: ($100,000 x .15) x 5 = $750,000. That means the borrower would owe $750,000 in interest over the five year loan period. When you include the principal of the loan, that person ends up playing $850,000 total over the five year loan period.

What Are Examples of Simple Interest?

Student loans and mortgages for homes often offer simple interest loans.

2) Compound

What Is the Definition of Compound Interest?

Compound interest is interest paid not only on the principal, but also on the interest from the previous pay period. So each month, the borrower is paying interest on the principal plus interest of the previous month, the principal plus interest on the month before that, and on until the beginning of the loan period.

What Is the Formula for Compound Interest?

The formula for compound interest is: Principal x [(1 + interest rate)n – 1].

In this calculation, “n” is the number of compounding periods.

What Are Examples of Compound Interest?

Compound interest is commonly associated with credit cards, or applied to less straightforward loans, like for investments and businesses transactions.

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Types of Interest Rates

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While simple and compound are general ways to calculate what is owed, there are also a number of different types of interest rates based on the real value of money.

1) Nominal Interest

The nominal interest rate doesn’t take inflation into account. That means you’ll be paying (or earning) the same amount on a loan over the life of the loan, regardless of inflation. Nominal interest can also refer to the interest on a loan before any fees or compounding interest or to the interest rate set by the Federal Reserve.

2) Real Interest

The real interest rate does take inflation into account. Real interest rates adjust with inflation and they are calculated by subtracting the expected or actual inflation rate from the nominal interest rate. This gives lending institutions an understanding of their spending power over time. Real interest rate is primarily used by lending institutions, investors, and borrowers -- in conjunction with nominal interest rate -- to make better decisions about their loans.

3) Variable Interest

Variable interest rates depend on the market. As the market interest rates go up and down, so too does the interest rate on a loan. Variable interest rates are often used on credit cards, mortgages, and loans.

4) Tiered Interest

With a tiered interest rate, the interest on a savings or checking account gets higher—or goes up a tier—as the amount of money in the account increases.

5) Long term Interest

Long term interest rates apply to government bonds that mature in ten years.

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How Interest Rates Affect the United States Economy

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The United States Federal Reserve plays an important part in setting two of three main national interest rates: the Federal Funds rate and the Discount rate. The third rate is the catch-all “Prime rate” which is set at the discretion of banks or other lenders the interest rate, which determines the rate that banks charge to borrow money from each other. That rate is then passed on to the end consumer, who becomes responsible for the loan amount plus fees.

The Fed has the power to raise and lower interest rates; it exercises this power to help keep the economy stable. To increase the amount of money circulating in the economy, the Federal Reserve lowers interest rates. Lower interest rates make it easier for households and businesses to borrow money from banks. The loans that banks make inject more money into the economy and allow it to recover from recession. When interest rates fall, families also tend to put less away for savings and spend more on consumer goods. Thus the effect of a falling interest rate is an increase in GDP through greater investment and less personal savings

When interest rates hit zero, however, increases in the money supply have no effect. Households and businesses no longer have an increased incentive to take out loans. The extra money sits in banks without being spent because checking accounts pay very low interest rates and cash doesn’t pay any interest rate at all. The higher interest rate consumers can get on CDs or bonds, the more they are willing to deposit their cash in those types of longer term investments. Thus, as the economy expands again, interest rates tend to rise.

How to Calculate Interest Rates Online

If you’re considering getting a loan or needing to make some other type of payment that will require budgeting interest, it is useful to first get a rough estimate of what that interest would look like. The formulas listed above might seem daunting to calculate by hand, which is why there are online interest rate calculators you can utilize.

The Payment Calculator can help you determine the monthly payment amount or loan term for a fixed interest loan.

The Interest Rate Calculator is good for real interest rates on loans with fixed terms and monthly payments.

The Interest Calculator can help you figure out the interest payments and final balances on fixed principal amounts and additional periodic contributions.

If the interest rates that you’re trying to calculate don’t fit under any of those categories, a quick search engine search for your terms should bring back an appropriate interest rate calculator.

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