Are you struggling to manage your debt? Then understanding interest rates is the key to getting a handle on it.
Interest rates have a major impact on any loan you take. There are various types that have different effects on the money you borrow.
You need to be aware of your choices when you experience adversities, and we have some solutions.
Interest rates vary depending on the loan. Understanding this fact helps you make better financial decisions. You need to know your options and what benefits your situation the most.
What are interest rates?
Interest is the cost of borrowing assets, like property, vehicles, and cash. It’s the amount lenders charge you on the principal (the loaned amount). A common term for it is “the cost of money”. Higher rates make it pricier to borrow the same amount of cash.
Lenders, like the United Financial Network (UFN), consider various factors when setting interest rates. They look at elements like market values, credit scores, federal policies, and competitors’ rates.
Interest rates aren’t only for loans. They also apply to certain savings accounts and certificates of deposit (CD).
In this situation, a credit union or bank pays you a percentage of the amount you deposited into your account. These deposits gain interest yearly as an annual percentage yield (APY).
Fixed vs. variable rates
There are two forms of rates a lender may charge you: fixed or variable.
Fixed rates stay constant over the loan’s lifetime. They typically include student and auto loans, and conventional mortgages.
Banks typically link variable rate loans to a benchmark. This reference point might be their prime lending rate (the lowest percentage they offer).
Adjustments to the prime rate change your loan’s interest rate with it.
Variable-rate loans include credit card debt and adjustable-rate mortgages (ARMs).
Annual percentage rate (APR) vs nominal rate
APR and nominal rate represent two distinct measures of interest rates in financial transactions.
The nominal rate focuses on the interest rate without considering inflation or compounding.
APR offers a broader view of the sum of the costs of a loan.
Here are the key differences you need to understand these interest rates:
APR:
- Reflects the sum of costs of lending money over a year. It includes closing costs, broker fees, loan origination fees, and the interest rate.
- You incur more fees the higher your APR is versus the interest rate. It ranges from 0.1% to 0.5% greater.
- A low APR costs you more monthly but results in a lower total loan cost. It’s better in the long term.
Nominal rate:
- The nominal rate calculates the interest expense on your loan. It doesn’t consider any other fees like APR does.
- Your data, like your credit score, determines your nominal rate.
- Low nominal rates provide smaller monthly payments but may equate to a more expensive loan total. Better for the short term.
How do interest rates affect loan costs?
Interest rates amount to the difference between the total repayment and the original loan. They also influence the full cost of your debt.
How interest rates affect your loan costs varies depending on the type of interest you get.
Two major types of interest influence your loan’s total cost: simple and compound.
Simple interest rate
Simple interest lives up to its name. It’s straightforward. You pay a percentage based on the original cost of the loan plus the original amount you borrowed.
The formula for simple interest is principal x interest rate x time.
For example, you borrow $100,000 from the bank. They give you simple interest at a rate of 3% annually. The amount you must pay back at the end of one year equals:
$100,000 + (0.03 x $100,000) = $100,000 + $3,000 = $103,000.
That means the interest you pay over a year equals $3,000. The same loan after 10 years looks like this:
$100,000 x 3% x 10 = $30,000
Compound interest rate
Compound interest rates benefit the lender more than simple ones do. They work for you when you’re saving, but put you at a disadvantage when borrowing.
Lenders who want you to pay more for the loan use compound interest. It applies to the principal and interest accumulated over time.
It’s essentially interest on interest.
Over shorter periods, like months, compound interest remains similar in value to simple. The difference between them grows the longer the term of the loan.
The calculation for compound interest is: principal x [(1 + interest rate)number of compounding periods – 1].
For example, let’s say you take a four-year loan of $200,000 at a 5% annual compounding interest rate. The total amount you pay back works out like this:
$200,000 x [(1 + 0.05)4 – 1] = $200,000 x [1.215506 – 1] = $43,101.2
The total cost of your loan equals $243,101.2 because of the compounding interest.
Factors influencing interest rates
Understanding interest rates involves knowing what influences them. There are several factors, ranging from the economy to the nature of the loan, the lender, and the borrower.
Here’s a breakdown of the key influences on interest rates:
Federal Reserve policies
The government has a major influence on interest rates. Banks set interest rates based on the federal funds rate. The United States Federal Reserve (the Fed) influences this rate using open market transactions (buying or selling previously issued US securities).
The interest rate goes down when the government buys securities and up when they sell. They either give the bank a lot of money or drain it.
Risk
Risk is a major factor influencing interest rates. Lenders may use the federal funds rate as a foundation but add to it as the risk increases.
Lenders consider your risk level to determine how much interest to charge.
Being low-risk means lenders are more likely to charge you less in interest.
The higher the risk, the greater your interest rate, and therefore, the larger the cost of the loan.
Here are the primary determinants of risk:
- Credit score: Determines your reliability to repay the loan. An excellent credit score means you’re more likely to make repayments. You pose less risk to lenders and qualify for lower interest rates.
- Loan amount: The more money you borrow, the greater the risk is to the lender. You may benefit from personal loan debt relief programs, but they’d prefer to avoid you needing them. Increasing the interest rate either deters you or benefits them more.
- Period of the loan: The longer the time frame for the loan, the higher the chance you won’t repay it. There is more opportunity for adversity leading to you defaulting.
- Inflation: As inflation rises, so do interest rates. The money lender’s loan loses purchasing power as time goes on. They must claim compensation for that decrease.
Supply and demand
Increased demand for cash and credit raises interest rates. When it decreases, so do the fees.
Supply works oppositely. When it increases, interest rates reduce. When it decreases, they rise.
More funds available to borrowers raises the supply of credit, which then decreases the cost of loaning.
The amount of credit the economy has access to reduces if you miss or delay repayments. Doing this increases interest rates because the supply went down and the demand didn’t.
Strategies to get the lowest interest rates
Understanding interest rates isn’t the only thing you need to manage your loans better. You also need to explore ways to reduce the rates you’re offered.
There are various methods to secure low interest rates and save money throughout your loan.
Here are the top six approaches:
- Improve your debt-to-income (DTI) ratio: Determined by dividing your total debts by your gross income (before taxes), times 100. The lower your DTI, the better. For example, lenders look favorably on 35% or below.
- Compare rates: Not all lenders use the same criteria to determine interest rates. Shop around to see your options or contact us to negotiate better terms on your behalf.
- Build your credit score: Ensure you pay your bills and debts on time. It increases your credit rating, reducing your risk level. Lenders are more likely to give you a lower interest rate.
- Make a larger down payment: Your down payment size directly influences your interest rate. Reduce it by offering a higher deposit on your loan.
- Debt consolidation: This method combines what you owe into one loan with one monthly repayment. We help you consolidate your debt and provide you with a lower interest rate compared to the average across all your dues.
- Try for a shorter loan term: They typically have lower interest rates but higher monthly payments compared to longer-term loans.
Pros and cons of long-term and short-term interest rates
Short-term interest rates typically move along with the Fed’s Federal Funds Rate.
Long-term interest rates experience more complex influences. These include the market, investors, and the Federal Funds Rate.
Here are the pros and cons of short-term loans:
Pros:
- No long-term commitment
- No need for collateral
- Gives you access to cash immediately
Cons:
- Qualifying for them is challenging
- Gives you access to less money
- Higher interest rates and more fees
Here are the pros and cons of long-term loans:
Pros:
- Interest rates and long-term costs are lower
- Gives you access to more money
- The repayment period is longer with smaller payments
Cons:
- Requires collateral
- Your loan might be inflexible, penalizing you for paying it off sooner
- Getting access to cash takes longer
How do interest rates affect different types of loans?
Each type of loan has a different interest rate that determines how much you repay.
Here are some different loans and how interest rates vary across them:
Mortgage loan
A mortgage is usually the largest type of loan you’ll ever take (houses are quite pricey after all). The interest lenders charge involves economic trends and your credit score.
The average interest rate for a 30-year fixed mortgage rate fluctuated between 14% and 7% over the past four decades.
Mortgage interest rates currently range from 6 to 7% between 15 and 30-year fixed mortgage loans.
Student loans
Lenders look to see if you have a stable income and a decent credit score (at least 670) when giving a student loan.
Federal student loans have fixed interest rates ranging from 5 to 8%. When the Fed raises its rates, it doesn’t affect your payments.
Private lenders have variable rates, meaning your payments see changes whenever the Fed raises their interest rates. They’re also higher for new borrowers, with averages ranging anywhere from 4 to 16%.
Credit card
Credit cards typically have higher interest rates because of a lack of collateral. They range from 21 to 28% depending on your credit score. The Fed also influences how lenders determine these rates.
Manage your balance well to avoid large amounts of interest. Defaulting leads to credit card debt, which hurts your credit score.
Manage your debt with the United Financial Network
Interest rates are the cost of borrowing money and the lender’s rate of return. They have a major influence on the total loan amount you pay.
Understanding interest rates may be confusing, but it means the difference between a large repayment and a reasonable one.
Navigating loan repayments may be challenging when you don’t understand interest rates. Mismanaging them and falling into debt isn’t the final straw. We offer solutions. Check if you qualify for our consolidation services today.
