What Are Interest Rates And Why Do You Pay Interest?

Unless you pay cash for every single purchase that you make; Interest affects every single part of our financial lives. Interest is charged on home purchase, auto loans, credit cards, home equity loans, personal loans, student loans, and all other loans. Interest is paid on savings accounts, interest bearing checking accounts, money market accounts, bonds, and other financial products. Higher interest rates on investment products puts the power of compound interest on your side helping you reach millionaire status faster. Higher interest rates on too many loans can place you in the poorhouse. Let’s take a look at what are interest rates. 

What is interest?

The interest rate is the “proportion of the loan that is charged as interest to the borrower typically expressed as an annual percentage rate of the loan outstanding.” The interest rate is the percentage of principal charged by the lender for the use of its money.

Why do you pay interest?

People often ask the question, why should I pay interest to borrow money if I can pay back the full principal amount within the stipulated time frame? There are a number of reasons why you are charged interest on loans.

Interest protects the lender against default

Interest is actually the cost of money. When you borrow money from a bank or financial institution, you are basically paying for the ability to use money that you do not have. The interest serves as a premium for the risk they take in lending money to you. The interest helps to protect lenders against the risk of default. Interest allows lenders to receive the original principal loaned out sooner. Borrowers with high credit scores receive lower interest rates because the risk of default is less likely. Bad credit borrowers receive higher interest rates because the risk of default is much greater. 

Interest provides a profit for the lender

Charging interest is how lenders generate a profit from lending money. The profit incentive is the primary reason that banks lend money. They lend money for the sole purpose of making money. Interest is the primary source of revenue generated by banks and other financial institutions who are in the business of making loans. The money loaned to borrowers could have been invested in other income producing assets. Interest helps to make sure that lenders are motivated to continue to lend funds.

Interest repays the lender’s interest

You pay interest on loans because money is not free. You may not have know this interesting fact. Banks pay money to borrow money! Banks pay interest to depositors in the form of interest on savings, money market accounts, and certificate of deposit accounts. Banks are also charged interest when borrowing money from other banks and the Federal Reserve. The interest charged by other banks is known as the Fed Funds rate,

Interest factors in inflation

One of the reasons for paying interest is because of the time value of money. A dollar today does not have the same value as a dollar tomorrow. This is due because to inflation. Inflation is a rise in prices. As the prices of goods and services rise, the purchasing power of a dollar decreases over time. So, $10,000 borrowed today and repaid five years later does not have the same purchasing power it did when originally borrowed.

What are the primary types of interest rates?

Fixed interest rates

As is evident from the name, a fixed interest rate is set at a certain percentage for the life of the loan. Fixed interest rates are common for home loans and auto loans. Borrowers make the exact same payment after month and interest is systematically paid down over time. Fixed rate loans make it easy to budget since your loan payment is the same each month. It is advisable to shop around for fixed interest rates, because once you zero in on a particular rate, you are stuck with that rate until the loan is paid off or refinanced.

Variable interest rates

A variable interest rate does just what the name suggests too – it varies. Depending upon the market and the interest rates offered by the institution, your provider can raise or lower interest rates. The changes affect the amount of interest you have to shell out every month. When you opt for a variable rate, you do leave yourself vulnerable to unpredictable market changes, but at the same time, you have the chance to reap the benefits if interest rates drop dramatically.

Comparison rate

This rate is actually used so buyers can understand better what a loan really costs them – it is given as a percentage value. Comparison rates include account interest rates, fees and charges so that you can easily compare what you are getting into while choosing a loan.

Remember that interest rates can fluctuate based on the product you are shopping for. A low interest home loan has interest rates that are in the single digits whereas a low interest credit card product may have an interest rate in the teens. Your interest rate expectations should be based on your credit score, income, financial product type, and down payment amount. Providing a down payment, getting a cosigner, or increasing your credit score can have a drastic impact on the interest rate offers your receive. 

Now that you know the basics about interest rates, be sure to shop around to find the best one for your purchases.

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