How do Interest Rates Work?

When you borrow money from a lender and have a debt that must be repaid, you are charged interest on your account. Interest is a percentage of the amount that you owe that is added to your balance periodically as a fee for using the money. Until you are debt free, it will continue to accumulate.

An interest rate is the percentage of the debt that is charged as interest. Every loan, mortgage, credit card, or medical bill that you ever will receive will have an interest rate associated with it. These can vary wildly between financial products, and also between consumers based on their credit histories.

It is very important for consumers to know how interest works, because otherwise you might not understand why your balance never seems to gets any lower even though you are making payments, or just how much your debt really is costing you. There are two basic types of interest: simple interest and compound interest.

Simple Interest

Simple interest is relatively straightforward. Also known as “flat rate” interest, it is taken as a percentage of the principal balance that is owed. The formula to calculate simple interest is:

Interest = Principal x Rate x Time

If you have a loan for $1000, for example, and your annual interest rate is 15%, then you would owe $150 in interest after one year:

1000 x .15 = $150

If your debt remains unpaid after three years, then the formula is altered slightly:

1000 x .15 x 3 = $450

At this point, your total amount owed would be $1450, $450 of which is interest. Accrued simple interest is based only on the original amount of the debt without any added fees or other interest. No matter how many months (or years) you go without paying your debt, your interest still will be based on that $1000.

You should note that while interest rates may be based on an annual percentage, they likely will be broken down into monthly or quarterly percentages.

Compound Interest

Compound interest not only is accrued on the original amount of the debt, but also on interest and fees that already have been added to the balance. It is much more common than simple interest. The formula to calculate compound interest is:

Amount (after “n” years) = Principal x (1 + Rate) ^ n number of years

Not so “simple” anymore, is it? Let’s revisit your $1000 loan after three years with compound interest:

1000 x (1 + .15) ^ 3 = $1520.88

With compound interest, you will be paying $70.88 more at this time than you would have with simple interest, because you are paying interest on interest. Compound interest rates are the reason bills to grow so quickly and it is so difficult to become debt free. It also prevents people from being able to lower their balances because much of what they pay is eaten up by interest costs. It is possible make payment after payment, and barely chip away at your actual debt.

The formulas above assume that interest fees are added once per year. For interest that is compounded on a quarterly or monthly basis, however, balances grow even more quickly. To determine interest on such a basis, you can use the following formulas:

Quarterly: Amount = Principal x (1 + (Rate / 4) ^ 4

Monthly: Amount = Principal x (1 + (Rate / 12) ^ 12

Most financial products utilize compound interest, so it is crucial to pay off your debts as quickly as possible. Always try to pay more than the minimum monthly payments on your debts, because otherwise becoming debt-free is improbable at best.

What about Credit Card Interest Rates?

Interest on credit cards and other financial products often is expressed as part of an Annual Percentage Rate (APR), which takes into account not only monthly interest but also other fees. Its purpose is to reflect the full cost of loan, and also to make it easier to compare with others. Unfortunately, it can be confusing when trying to discern interest payments, so ask your lender for the interest rate in and of itself.

Is there any way to lower my interest rate?

The most foolproof way to lower your interest rate is to improve your credit report and score, because lenders use these tools to decide whether to lend to you and at what rate. The less “risky” that they determine you are, the better interest rate you may receive.

You can improve your credit substantially by correcting errors, removing negative marks, and utilizing other credit repair tactics. If you already have an interest rate on an account that you would like lowered, then you should call your lender and ask if this is possible. Really! Many companies respond positively to such initiative.

Interest rates are a fact of life, so understanding how they work is crucial to financial planning and debt repayment. Do not ignore the influence that a compound interest rate can have on your desire to become debt free. But also remember that interest can work for you just as well as against you! Keep your money in a savings or money market account, and watch it grow.