Interest rates play a big role in the personal finance world.
Interest rates can help you when you are saving and investing, and interest rates can hurt you when you borrow money.
But what do you know about interest rates? Are there different kinds? What financial instruments use them?
When you receive interest
There are a few financial products that will pay you interest.
- Savings account – Generally where most money goes if it’s not being used for paying bills or other types of regular expenses. The interest rate on a savings account is generally pretty low. Sometimes as low as .01%.
- Money market account – This type of account is pretty similar to a savings account. The only difference is this type of account generally pays a much higher rate of interest. Sometimes it can be as high as 1.75%.
- Certificates of Deposit (CD) – A certificate of deposit is another savings vehicle, but is a little more constricting. You deposit money into the account and it stays there for a set period of time while collecting interest. You are not allowed to withdraw that money, if you do, you will pay a penalty. After that period of time is over, you get your money back. The longer you have the money “tied up” for, the higher the interest rate you will receive.
- Bonds – A bond is debt issued by a company. They issue bonds to raise funds for a variety of reasons. If you are a bondholder, the company will pay interest every six months until the bond matures, at which time, you will receive your initial investment back in the amount of $1,000 per bond. The interest rate paid by the company will vary by how likely that company is to fulfill those promised interest payments. The larger more established companies usually pay less than the smaller, up and coming companies.
What charges you interest
There are really only two instruments that charge you interest. Loans and credit cards.
A loan is something you apply for when you need money. In most cases, you will apply for a loan when you want to buy a house or when you want to buy a car.
There are other, less common, instances when you will apply for a loan to assist your other debts. This comes in the form of a personal loan. You get a personal loan to escape the crazy high-interest rates of credit cards.
Credit cards are the other instrument that charges you interest. If you use your credit card to make a purchase and fail to pay that balance before the end of the month, you will still owe the remainder of your balance, plus interest.
Credit card interest rates can get as high as 36%. (Source)
Types of interest rates
There are many different types of interest rates:
- Simple interest – The interest rate times the principal amount. For example, you have $1,000 in a hypothetical bank account and the interest rate is 5%. The interest you would receive would be $50 annually.
- Compound interest – This is interest upon interest. Let’s stick with the first example. You have $1,000 and a 5% interest rate. Now you will leave that money banked for 5 years. After the first year, you have $1,050. Now the 5% interest rate will be applied to $1,050 so you end year 2 with $1,102.50. By the end of year 5, you have $1,276.29.
- Amortized – The most common example of an amortized loan is a mortgage. At the beginning of your mortgage, most of your payment is going towards interest, with each passing month and year, however, more of your money will go towards the principal and less to interest. We will use an auto loan as an example. You have an auto loan of $20,000 with a 6% interest rate and a 5-year term. The first payment you make breaks down to $286.66 to the principal and $100 to interest. The last payment you make is $384.73 to principal and $1.93 to interest.
- Fixed – When you apply for your loan and get quoted an interest rate. That’s the rate you will pay for the entirety of the loan.
- Variable – A variable rate is the exact opposite of a fixed rate because it can change. Your credit card’s APR is a good example of a variable rate. There is another interest rate, called the discount rate, that is set and by the Federal Reserve. As that rate changes, the variable rates also change.
- Prime rate – This type of rate is used by banks and is used when banks lend money to it’s best customers; usually customers with good credit.
- Discount rate – This rate is set, as mentioned above, by the Federal Reserve. We are currently, and have been for the last two years, in a rising rate environment. The Federal Reserve has raised the discount rate by a quarter of a percent 7 times in the last 2 1/2 years. This rate is what the FED uses when lending to other institutions, and when this rate changes, all other rates are affected (except for fixed rates).
- APR – This is the rate used for credit cards. APR stands for Annual Percentage Rate. The APR, as mentioned above, is a variable rate, so when the discount rate changes, this rate also changes.
- APY – The rate of interest earned, at a bank or credit union, from a savings account money market account or CD.
There are several different types of interest rates. Some interest-bearing accounts can hurt you and some can help you. It’s important to know which is which because interest rates will play a part in your financial life, forever.
So readers, what questions do you have about interest rates?