Interest Rate

Interest Rate
An Interest rate is the amount being charged for borrowing. It’s a percentage of the amount you borrow. For instance, if you borrow $100 at an interest rate of 20%, then you will pay back $100 plus another $20 of interest. Having a goodcredit score will make it easier to find lower interest rates.

What is an Interest Rate?

Interest is the cost of using someone else’s money or assets. When you borrow, you’re charged interest: you’re paying a fee, set by the institution you are borrowing from, in order to ‘rent’ whatever it is you’re borrowing, whether it’s cash, a building, or a vehicle. An interest rate, then, refers to the amount you are charged for borrowing. Interest rates are always written as a percentage of principal, which is the original amount borrowed.(1)

If you have a savings account at a bank, you will earn interest on the money in your account. This is because you are lending your money to the bank so that they can use it to make loans. If you take advantage of savings accounts that offer compound interest, your money will grow even faster because your interest will earn interest.

Types of Interest Rates

There are different kinds of interest rates. When borrowing or applying for a loan, it is important to be familiar with the different types as well as what the terms of your specific loan are. Being informed of the terms of your loan and the type of interest rate applied to your loan will ensure you don’t experience any surprises down the road. A higher interest rate means you will pay more for borrowing the same amount of money. Interest rates are based on risk. In other words, if someone is lending you something, your interest rate is based on how likely you are to return the money you borrowed. Risk is frequently determined by your credit score. You can receive lower interest rates if you are deemed a ‘low-risk borrower’ and will be charged higher interest rates if it’s decided that lending to you poses a greater risk.

Simple and Compound Interest

The most basic type of rate is called simple interest. Simple interest can be calculated by multiplying the principle by the interest rate and length of loan or term. It’s paid once and does not change.

Another type of interest rate you will often see is compound interest. Frequently used with credit cards and savings accounts, compound interest rates will change based on the principle of your loan in addition to interest accrued on the loan or account.(2)

Amortized Interest

Amortized interest rates are interesting because when the borrower first receives the loan, they will pay smaller parts of the principle off and larger amounts of interest. As time passes, they will pay more of the principal which decreases the amount of interest charged on it. So the amount of interest charged will shrink over time simply based on the principal going down, even though the interest rate remains the same for the life of the loan.

Fixed Interest

Fixed interest rates will stay the same over the life of the loan and they are predetermined. Fixed rates are frequently used in long-term lending, such as mortgage loans. They are different from simple interest however, because you will pay interest many times, not just once. The opposite of fixed rates are variable rates. Variable interest rates can increase or decrease on a monthly basis based on current index values, which are basically just benchmark rates set by the market.

Prime Rates

Prime rates are rates that banks reserve for borrowers who have the highest credit ratings. Based on the federal funds rate (the rate that banks use when lending and borrowing from each other), prime rates are most commonly given to large corporations. Despite this, the prime rate still has influence in the average consumer’s finances as personal loan and mortgage rates are influenced by the prime rate.

How do Lenders Determine Interest Rates?

So you’ve decided that you would like to take out an unsecured (no collateral, interest is based on creditworthiness) personal loan from a bank. The way the bank will determine your interest rate is not arbitrary — far from it, actually. It can seem fairly complex to those of us who are not bankers. Let’s just start with what you, the consumer should be aware of regarding how your rate will be determined. There are many different factors and models used to set interest rates. The most frequently used models are the cost-plus model and the price-leadership model. Both of these models take risk into account as well.(3)

When using the cost-plus pricing model, determining the interest rate takes four components into consideration. The first is the bank’s funding costs. This is how much money the bank spent on raising the funds to supply you with the loan, either through customer deposits or money markets. Second, they will calculate their operating costs, which include bank employee wages and payment processing fees. Next, your risk premium is determined, which is how likely the bank believes the loan is to go into default. Lastly, they will consider their own profit margins, because when everything’s said and done, the bank wants to make money on the money it lends.

The price-leadership model is a bit different from the cost-plus model in that it takes other rates by major banks into account. Banks are always competing with each other for your business, so they will do all they can do decrease their own operating costs to increase their own profit margins.

Determining Risk through the 5 C’s of Credit

In lending, risk is determined by banks through the ‘5 C’s of Credit’. Don’t think of the 5 C’s as a strict rule by any means, it’s simply a useful tool to evaluate borrowers. It is entirely up to the lender to determine how much value they place on the various attributes.(4) The 5 C’s include character, capacity/cash flow, capital, conditions, and collateral. Assessing a borrower’s character is important because banks want to lend to credible people they can trust to repay the loan; they will use a borrower’s references, credentials, and previous interactions with lenders to formulate their opinion of one’s character.

Capacity is simply the borrower’s ability to repay the loan. The bank isn’t lending money for their health, they’re after that profit margin. A few items go into the assessment of a borrower’s capacity including credit score, borrowing and repayment history, and the loan application which will include details on how and when the loan will be repaid. Capital is interesting because it certainly will not apply for the majority of student borrowers or small-loan applicants. It refers to the amount of money invested into the project or venture by the borrower. This is typically used in large loans given to companies. Banks want to determine if company owners have invested because this gives the lender an idea of how much “skin in the game” the borrower has. The bank does not want 100% of the risk to fall on their shoulders.

Conditions are, again, all about the risk involved in lending. A bank or lender will assess conditions such as current economy as well as how the loan will be used. Basically, banks want to loan to companies who are operating in favorable market conditions. If you’re trying to open a cupcake shop during a time when everyone prefers doughnuts and hates cupcakes, you may not get that loan due to unfavorable conditions for turning a profit in the cupcake business. A borrower’s ability to provide collateral should they default on their loan is assessed in lending as well. Collateral can be any valuable assets that the borrower owns such as a home, real estate, company inventory, or company equipment.

How can I get the Lowest Interest Rate Possible?

Refinancing and shopping around aside, there is one proven way to make sure you are afforded a low interest rate on a loan or home mortgage and that’s keeping your finances in check. This means staying on top of your credit score, paying debts and bills on time, and staying informed. As a general starting point, interest rates on unsecured loans are higher than loans backed by property, so just keep that in mind. Unsecured personal loans will rely heavily on your credit score to determine your interest rate. Similarly, the better your credit history, the more likely you will be to be approved for lower interest credit cards. Bottom line? Care for your score!

References:

  1. “What is ‘Interest Rate'”. Investopedia. Accessed March 28, 2016. https://www.investopedia.com/terms/i/interestrate.asp
  2. Evans, Linsay. “7 Kinds of Interest Rates”. The Motley Fool. Accessed March 28, 2016. https://wiki.fool.com/7_Kinds_of_Interest_Rates
  3. Diette, Matthew D. “How Do Lenders Set Interest Rates On Loans?” (November 1, 2000). Federal Reserve Bank of Minneapolis. Accessed March 28, 2016. https://www.minneapolisfed.org/publications/community-dividend/how-do-lenders-set-interest-rates-on-loans
  4. Amolm. “The 5 Cs of Credit”. NerdWallet. Accessed March 28, 2016. https://www.nerdwallet.com/blog/5-cs-credit/