Understanding What Are Interest Rates And How They Work
Monday, November 06, 2006
One form of interest familiar to most of us is on our credit
card purchases. We are charged a monthly interest rate on our
unpaid balances. If you spend $100, you will be charged
interest each month for the portion of the original loan
remaining. If you pay $20 on the loan in the first month, you
will reduce the loan to $80. The next month, however, you will
have to repay $80 plus the monthly interest.
The Federal Reserve Bank sets the interest rates. These are
raised when the economy is "heating up." This has the affect of
decreasing consumer spending by adding greater interest to
financed purchases. When the economy begins to slow down,
interest rates may be lowered by the Federal Reserve Bank to
increase consumer spending. With lowered rates, consumers tend
to use their credit cards more often and finance more purchases
of major appliances and cars.
Interest rates vary. You may have a fixed rate of interest.
This where the lender sets the rate of interest when the loan
is made. The rate never changes over the length of the loan. If
you borrow, $100, you agree to repay $100 plus interest, 10% for
example, over a fixed period of time. The total amount of the
loan would then be $100 plus 10% interest or $110.
There are also variable interest rates. Here you agree to repay
a loan, but the interest rate is subject to change and the
amount of interest is calculated on the monthly balance. If you
borrow the same $100, you will owe $100 the first month. You pay
$10. In the next month you will owe the remaining amount of the
bill, $90, plus the interest for that month, 10% for example.
In effect, you will now owe $99, despite the fact that you have
paid $10 against your loan. If you repeat your payment of $10
the following month, you will now owe $89 plus 10% or $97.9.
You can see that after paying $20 on your loan, you have only
lowered the amount by $2.10. This is why you should not keep
high balances in variable rate accounts.
The lender sets the rates for your loan. This is because he/she
sees you as a risk. Interest rates depend on your credit
history. If you have good credit, the interest may be lowered.
If you have bad credit, then the risk is greater and your
interest rate is going to be higher. Lenders can quickly learn
your credit history by looking at your credit report.
The length of the loan affects your interest. Financial
institutions are likely to offer you lower interest rates if
you obtain a loan with a longer repayment time. Instead of
repaying your $100 plus 10% over one year ($110), the bank
might give you an interest rate of 8% over two years, costing
you $116. While $6 interest may not seem like much, you can
imagine what the interest would be if the loan was for $1,000
or $100,000.
There is also interest paid on investments. One of the most
common forms of investment is a savings account. Here interest
is calculated on the amount of money you invest and how long
you leave it untouched. If, instead of borrowing $100, you put
it into a savings account and left it there for one year, you
will have $100 plus the bank's interest rate. If the bank paid
5% interest, you would have $105 at the end of the year. If you
left the money in the bank for another year, you would have $105
plus 5% interest or $110.25. The more money you place into a
savings account, the greater the amount of interest the bank
will have to pay you.
About The Author: Read more from Joe Goertz at:
http://www.finance-mag.com
posted by Dennis Cheesman @ 5:21 AM,
