How Interest Rates Work

Interest is a simple concept with a lot of complex details. Sometimes, those details scare people away from understanding the idea of interest fully. But understanding how interest rates work helps you make better money management decisions, potentially saving a great deal on the cost of loans and debt over time.

What Is Interest?

Interest is the amount you pay for the privilege of using someone else’s money. In the case of money you own, such as a savings account, interest is the amount you earn when you let someone else use or hold your funds.

For example, if you borrow $5,000 at a simple interest rate of 3% for five years, you’ll pay a total of $750 in interest. The formula for simple interest is A = P (1 + rt).

  • A is how much you pay over the total life of the loan, including interest.
  • P is the principal amount. This is how much you originally borrowed.
  • r is the rate of interest per year. In this case, it would be written as 0.03. That’s how 3% is written as a decimal.
  • t is the total time in years you’ll use to pay off the loan.

In this example, the interest cost is calculated as follows.

A = 5,000 (1 + (0.03 * 5))

A = 5,000 (1 + 0.15)

A = 5,000 * 1.15

A = 5,750

Not all interest totals are calculated using the simple interest model. But this example provides a good look at how different rates can change the total amount you pay. Using the same calculation but with a 10% interest rate, for example, the total amount paid for the loan is $7,500. The cost is $2,500 in that case, which is much more than $750.

What Is APR?

APR stands for annual percentage rate. Sometimes, it’s used interchangeably with the term interest. For accounts such as credit cards, APR is typically accurate. But with other types of loans, the APR could also include fees associated with the loan. That makes the APR slightly higher than the actual base interest rate.

Ultimately, APR attempts to provide a measurement for how much the overall loan or credit costs. It’s important to consider both the base interest rate andthe APR when you’re shopping loans or credit cards. Using APR to compare options is a good idea because it lets you look at the total cost in one easy number.

To calculate APR, you:

  • Add the fees and the interest paid over the life of the loan
  • Divide that by the loan amount
  • Divide that by the number of days you’ll take to pay back the loan
  • Multiply that by 365
  • Multiply again by 100

Consider the example above borrowing $5,000 at 3% over 5 years, but add in a $150 administration fee for the loan. The APR is calculated as follows.

  • 150 + 750 = 900
  • 900/5000 = 0.18
  • (0.18/1825) * 365 = 0.042
  • 042 * 100 = 4.2

The APR for this loan is 4.2%. You’ll notice that it’s higher than the 3% interest rate because it takes all costs into account.

How Is Your Interest Rate Determined When You Borrow Money?

You can see that a lower interest rate can save you a lot of money on debt. Understanding how interest rates work so you can get the lowest possible rate is important.

Your interest rate is typically the product of three major factors: the base rate, the lender’s policies and your own credit history. The base rate is set by market factors, including the Federal Reserve’s current requirements. Lending policies about consumer interest rates may be impacted by the cost of doing business for each bank and other factors that are also out of your control.

Why Your Credit Score Matters

Your credit score, however, is within your control. Good and excellent credit scores tend to garner the best APR offers. Fair credit scores get mediocre offers, and poor or bad credit ratings may mean you face high interest rates or can’t get credit at all.

Specific Types of Interest Rates

Interest rates also work differently for various types of loans. The considerations you might have when dealing with a mortgage, for example, are different from those related to credit card accounts.

Credit Card Interest Rates

Credit cards actually have multiple interest rates depending on the type of balance you’re carrying and how you manage your account. Balance transfers, cash advances and purchases may all come with different rates, for example. This is especially true when you have a card with a low APR introductory offer.

But credit card companies may charge what is called a penalty APR too. This is charged on late fees and may also be charged on your entire balance if you fail to make payments in a timely manner. Penalty APR is generally more than your regular APR.

Some credit card companies publish a daily periodic rate, or DPR. This is the number used to calculate interest charges on your balance if you carry it forward. The DPR is simply the APR divided by 365.

When you’re comparing rates between cards to make a decision about which one is right for you, make sure you’re comparing the same figure. Don’t compare APR to DPR.

Consider these two examples to understand how credit card interest rates impact how much you pay in total. Making similar payments on the same balance over the same time period, the cost is still more than $200 more with the higher interest rate.

  • A balance of $3,000 at an interest rate of 11.99%
    • Paid off in 25 months with a monthly payment of $141
    • Total paid: $3,525
  • A balance of $3,000 at an interest rate of 21.99%
    • Paid off in 24 months with a monthly payment of $156
    • Total paid: $3,744

Mortgage Interest Rates

The same truths impact mortgage payments, but you’re typically dealing with much higher debt amounts and term lengths. That means higher interest can cost you even more.

Mortgage APRs typically include fees such as origination fees, mortgage insurance and even taxes. You can roll these fees into the loan or pay them separately. If they are rolled into the loan, they increase the total cost of borrowing, thus increasing the APR. When comparing mortgage APRs, make sure you understand whether fees are included.

The total cost of mortgage loans also depends on other factors, including how long you financed the property. The longer you finance for, the more you’ll pay if all other factors are the same. Consider the examples below.

  • $100,000 mortgage at 3.92 interest for 30 years equals a total cost of $170,213 and a monthly payment of $473
  • $100,000 mortgage at 3.92 interest for 15 years equals a total cost of $132,423 and a monthly payment of $736

But a higher interest rate can also increase the amount you pay for your home. That’s true even over the same time period. A single point in interest can add tens of thousands of dollars in cost. You can see why many people refinance or make mortgage decisions based on half a percentage point in interest.

  • $100,000 mortgage at 3.92 interest for 30 years equals a total cost of $170,213 and a monthly payment of $473
  • $100,000 mortgage at 4.92 interest for 30 years equals a total cost of $191,499 and a monthly payment of $532
  • $100,000 mortgage at 5.92 interest for 30 years equals a total cost of $213,990 and a monthly payment of $594

Your mortgage APR — and whether you can get approved for a home loan— depends heavily on your credit score. The state you live in, what type of property you want to buy, how much you’re putting down and the type of lending you qualify for all also play a role in determining your mortgage rates.

Auto Loan Interest Rates

Auto loans come with a lot of lingo, and it’s easy to get confused. Make sure you understand all the definitions related to your auto loan before you sign paperwork.

Generally, auto loans are calculated using simple interest. But the APR can include many fees, including sales tax, title fees and even paperwork fees from the dealership. You can save money on car loans by negotiating some of these fees when possible or paying them outright instead of financing them. And you can save even more by scoring a lower interest rate.

How to Get the Best Interest Rate

Remember that not all factors that drive interest rates are in your control. But your credit score, which plays a major role, is something you can attend to. Before you make a big credit purchase or seek a new credit card, consider getting your financial ducks in a row.

Order your credit report to find out what your score is and whether you can take action to improve it. That might involve fixing mistakes on your credit report or paying down balances to lower your credit utilization. Sign up for services at to get access to your credit reports to start the process.

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