When you borrow money, you have to pay close attention to your agreement. It contains a wealth of information about your borrowing costs, payment timeline and other terms. One of the most important terms is the interest rate. Learn more about how interest rates work and how they’re likely to affect your finances.
What Is Interest?
Before you learn how interest rates affect your debt, you need to know what interest is. In simple terms, interest is the cost of borrowing money. When you open a credit card or take out a loan, the lender isn’t loaning you money out of the goodness of your heart. They’re doing it to make a profit. Charging you interest is how they make money.
Interest rates are expressed as a percentage. For example, you may qualify for a mortgage with a 6.5% rate or a personal loan with a 12.5% rate. Note that your interest rate is not the same thing as your annual percentage rate, as it includes other charges, such as discount points and origination fees.
Interest Rates on Mortgages
Your home is one of the most expensive purchases you’ll ever make, so it’s important to understand how interest rates affect the cost of taking out a home loan. In November 2024, the average mortgage rate in the United States reached 6.79%. Although mortgage rates are much lower than the interest rates on most credit cards and personal loans, a high rate can cost you significantly.
Assume that you want to purchase a home for $350,000. You plan to make a 10% down payment ($35,000) and finance the rest. At an interest rate of 6.79%, you’re looking at a monthly payment of $2,051. This doesn’t include the cost of homeowners insurance or property taxes. It also assumes that you agreed to a 30-year repayment period.
Your interest rate greatly impacts the total cost of your home purchase. In the example above, a 6.79% interest rate on a 30-year loan would cost you $422,636 over the life of the loan — well over the original purchase price of the home. If you kept everything else the same and increased the interest rate to 7.5%, the total interest paid would increase to $476,866. This difference is more than $50,000, highlighting the importance of shopping around for the best rate.
Interest Rates on Credit Cards & Installment Loans
Interest rates work much the same way on installment loans and credit cards. The higher your interest rate, the more you pay in the long run. However, installment loans and credit cards have different rates. In August 2024, the average rate for a 24-month loan at a commercial bank was 12.33%.
For well-qualified buyers, the rates on auto loans are typically lower than the rates on personal loans. This is because auto loans are secured, while personal loans are unsecured. In layman’s terms, a secured loan is a loan backed by some type of asset or an object that has value.
If you don’t repay your auto loan, the bank can seize your vehicle, sell it and use the proceeds to cover your debt. In September 2024, the national average rate for a 60-month loan on a new vehicle was 7.50% at banks and 6.27% at credit unions. The average rate for a 48-month loan on a used vehicle was 7.8% at banks and 6.34% at credit unions.
Most credit cards are unsecured, so they aren’t backed by any valuable assets. Since the bank takes on more risk, interest rates for credit cards are generally much higher than they are for personal loans and auto loans. As of September 2024, credit unions were charging an average rate of 12.9% for credit cards, while banks were charging an average of 15.75%.
What Causes Interest Rates to Change?
The Federal Open Market Committee (FOMC) determines the federal funds rate, and this is the rate financial institutions charge one another to borrow money. Banks use the federal funds rate to determine their prime rates or the rates charged to their most qualified borrowers. The prime rate helps determine the bank’s interest rates for personal loans, auto loans, credit cards and mortgages.
When setting the federal funds rate, the FOMC has to think about the unemployment rate and inflation rates. Lowering interest rates typically increases inflation, as it increases the money supply. Conversely, increasing rates help ease inflation, as fewer people can afford to borrow money when interest rates are high.
How to Qualify for the Lowest Rates
One of the best ways to qualify for a low interest rate is to maintain good credit scores. A high score shows lenders that you’re responsible with credit, so they’re more likely to offer attractive rates. If you miss payments or default on your debts, however, lenders may charge you a higher rate to make up for the increased risk of allowing you to borrow money.
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