What Are Interest Rates and Why Do They Matter?

If you're looking for a loan for the first time, or hoping to grow the money you have saved, understanding how interest rates work is crucial.

An interest rate is what a lender charges the borrower over time, and even a low rate can dramatically add up. When you borrow money, you pay interest to the financial institution. And although we don’t usually think of ourselves as lending money to banks, we do exactly that when we open a savings account says Stephen Brobeck, senior fellow at the Consumer Federation of America. The good news is, you get it back—with interest.

There is a hitch, though. One of the main ways banks, savings institutions, and credit unions stay in business is to “borrow” money from you at one interest rate and lend it back to you at another, higher rate. For example, you may earn 1 percent interest on your savings account balance while the bank’s starting interest rate on a car loan is 4.2 percent. Here’s how to make interest rates work for you.

How to Get the Lowest Interest Rate on a Loan

To pay the least amount of interest on a loan, start by researching rates online. Websites like Bankrate will give you an idea of what’s available from different lenders in your area, whether you’re applying for a credit card, a personal loan, or a mortgage. Once you have an approximate idea of the current interest rates, ask your bank or credit union for one that is comparable or lower.

What causes interest rates to increase or decrease? Various factors, but perceived risk and your personal credit score play big roles. Whatever kind of loan you need, it is important to check your credit report before you apply. Contact any or all of the three agencies that report your credit activity—Equifax, Experian, and TransUnion—for your free annual report. Review what is in the report, and fix any errors promptly by contacting the agency if necessary.

The National Endowment for Financial Education advises all consumers to take time to understand how lenders see them. If you have a lower credit score, lenders will see you as a higher risk and will charge you a higher interest rate. The difference between having an excellent credit score and a poor one on a 30-year, fixed-rate mortgage could easily amount to hundreds of thousands of dollars paid in interest, according to the NEFE.

The interest rates on consumer debt—a credit card or an auto loan—are higher than the rates on a student loan or a mortgage. This is because financial institutions see student loans and mortgages as safer investments. The logic: People who further their education generally go on to earn more money, and homes tend to increase in value over time.

Understand the Costs of a Loan

What fees are included? Is there a penalty if you pay off the loan early as a way of saving on interest? Is the interest rate fixed, which means it stays the same for the life of the loan—or variable, which means the rate fluctuates with the market?

Note whether the interest you will be charged is simple or compound. With simple interest, you are only paying interest on the principal of the loan, or the money you still owe the lender. If you don’t pay off a credit card in full each month, you are generally charged compound interest. This means that the interest is calculated as a percentage of the total owed, and that added interest becomes part of the new total for the next time the interest is calculated (which is done daily in some cases). The interest builds on itself.

What that means is, if you owe $5,000 on a credit card with an interest rate (generally called the annual percentage rate, or APR) of 18 percent, and you pay only the minimum of, say, 2.5 percent each month, it will take you more than 60 payments, or more than five years, to pay off the balance. The amount added on in interest? More than $2,500, or a whopping 50 percent of the initial debt.

Get the Highest Interest Rate on a Savings Account

While shopping for the lowest interest rates for any money you borrow, you’ll want to find the highest interest rates for any money you save. Regardless of your financial situation, it’s a good idea to have a cash cushion that can cover your household and other routine expenses for three to six months in the case of job loss or a large emergency expenditure, says the Consumer Federation of America's Brobeck. To safeguard that money, you want to find a risk-free account where the money is available to you as needed—and with the best interest rate possible.

Interest rates typically vary based on the type of savings account.

Traditional savings accounts: Traditional savings accounts pay relatively low interest (the national average is .07 percent in the U.S. according to the Federal Deposit
Insurance Corporation), but you often only need to keep a daily minimum balance of $300 to $500—or less, if you set up a regular automatic deposit into the account. Internet-only banks generally offer somewhat higher interest rates, with no minimum balance requirement, but withdrawals can take a few days.

High-yield savings accounts: Mostly available from internet-only banks and credit unions, high-yield savings accounts can offer interest rates that are up to 25 times higher than a traditional savings account. These accounts often offer somewhere between 1 and 2 percent APY, but the rates are typically flexible, which means they will fluctuate in response to changes in the economy. Some may also have initial deposit or minimum balance requirements.

Money market accounts: Available from traditional and internet-only banks, money market accounts tend to pay higher interest, but the minimum balance requirement is often $2,500 or more.

Certificates of deposit: CDs tend to offer the highest interest rates, between 0.9 percent and 3.3 percent, but there is often a minimum investment of at least $1,000 for a fixed period of time, such as one year. During that time, you typically cannot withdraw the money without a penalty.

None of these accounts offers a particularly high interest rate—in fact, savings account interest rates have hardly kept up with the rate of inflation, which is hovering at about 2 percent. The real advantage is that a savings account offers you a risk-free way to slowly grow your money.