Interest rate

An interest rate is a price, and like any price it is quoted per unit: a percentage of the balance, per year. A lender charges it on the money you owe, a bank pays it on the money you keep with it, and the same 4.00% means the same thing on either side of the counter. The rate is stated per year but applied per month or per day, to whatever the balance is at the time, which is how 6.9% on a $20,000 loan becomes $115 of interest in the first month and $113.39 in the second, once the first payment has cut the balance.

In a sentence

• "The savings account pays a 4.00% interest rate, which comes to $33.33 the first month on $10,000."
• "The loan's interest rate is 6.9%, and its APR is about 7.5% once the $300 origination fee is counted in."
• "A fixed interest rate stays where it was set for the life of the loan; a variable one moves with the prime rate."

How it works

1. The rate is stated per year, before compounding and before fees.
2. The lender or the bank divides it into the period it uses. Loans are usually scheduled by the month, so the period rate is the annual rate divided by twelve; credit cards, and many savings accounts, work in days, so it is the annual rate divided by 365.
3. The period rate is applied to the balance outstanding in that period. On a loan that is the remaining principal; on a card, each day's balance; on a savings account, the balance on deposit.
4. The interest is either paid or added to the balance. A loan payment covers it; a savings account credits it to the balance, and a card adds it to a carried balance, where it earns or charges interest itself next period, which is compounding.

Interest for a period = balance × annual rate ÷ periods in the year

Rates come in a few kinds, and a loan or an account names which one it has.

An example

The same arithmetic on three balances, with each rate as the example's assumption.

The savings interest is added to the balance, so the second month earns on $10,033.33 and a year comes to $407.42, a little more than 4.00% of the deposit; that compounding is what an APY reports. The car loan's $115 is covered by a $395.08 payment whose other $280.08 reduces the balance, so the second month's interest is $113.39 and the interest share falls from there; over sixty payments the loan costs $3,704.90 in interest. At 9.9% the same loan would cost $5,437.43, and at 3.9% $2,045.69: three points of rate is about $1,700 either way.

Why it matters

The interest rate decides what a balance costs to keep and what a deposit earns to hold, and on a loan it sets the payment. It is what to compare when two offers are for the same product, and on a loan the APR, which folds in the fees, is the better comparison. The mistake it prevents is judging a loan by its payment: a longer term lowers the payment and raises the total interest, and only the rate and the term together say what the loan costs. On savings, the rate is the reason to move money to an account that pays a real one; on debt, it is the reason the highest-rate balance is paid first.

Interest rate versus APR

The interest rate is the cost of the money alone; the APR is the interest rate plus the required fees, spread over the term, so it is usually a little higher on a loan and identical on a credit card, which has no fees folded in. A $20,000 loan at 6.9% with a $300 origination fee has an APR of about 7.5%. The rate is the number the payment is computed from, and the APR is the number two offers are compared on. On the saving side the equivalent pair is the rate and the APY, which adds the effect of compounding: a 4.00% rate credited monthly is a 4.07% APY.

Common questions

Is the interest rate the same as APR? On a credit card, yes. On a loan the APR is the interest rate plus the required fees expressed as a rate, so it is slightly higher, and it is the better figure for comparing two loans. The interest rate is the one the monthly payment is calculated from.

What is a good interest rate? It depends on the product, on your credit, and on the year. Mortgages and car loans run far below credit cards, and within each product the range is wide. Compare offers of the same kind against each other on the same day.

How is a yearly rate turned into a monthly charge? Divide it by twelve and apply it to the balance. A 6.9% rate is 0.575% a month, which on $20,000 is $115. A card divides by 365 instead and applies the daily rate to each day's balance, which comes to about the same as a twelfth of the APR over a month.

What is the difference between a fixed and a variable interest rate? A fixed rate is set when the loan is made and stays there. A variable rate is an index, usually the prime rate, plus a margin, and it moves when the index moves, so the interest on a card balance or a variable-rate loan changes with it.

Does the interest rate on savings compound? Yes, in almost every savings account. The interest is credited to the balance, monthly at most banks, and the next month's interest is calculated on the larger balance. The APY is the rate with that effect included.

Go deeper

• The Loan calculator turns an amount, a term and an interest rate into the monthly payment and the total interest, and shows how much sooner the loan ends if you pay a little extra each month.
• The Credit card payoff calculator shows how long a balance takes to clear at its APR and the payment you make now, and what to pay each month to be done by a date you choose.
• The Compound interest calculator shows how a starting balance and a monthly contribution grow at a given rate over the years, and how much of the final amount is interest on interest.