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What Are Interest Rates?

The interest rate is the price you pay for a loan.

“What are interest rates?” is a question that anyone who has heard the financial news or read a credit card statement has asked at some point. The interest rates mentioned in the news apply mainly to banks borrowing from the government, but there are other interest rates that affect you personally. You come across these rates whenever you take out a loan or put savings in the bank.

How Interest Rates Work

When you borrow money, the interest rate is the price you pay for the loan. You owe your creditor the original amount of the loan—known as the principal—and additional money called interest. A high interest rate can turn a small loan into a large one over time, especially when the interest is compounded. Compounding means that the interest you owe is added to the principal of the loan. In the future, your interest rate applies to both the principal and the previous interest. For example, suppose you owe $100 and pay a 10 percent interest rate per year. Assume you make no payments and incur no missed-payment penalties. At the end of the year, your debt grows to $100 plus 10 percent of $100, or $110 total. If the interest is then compounded, the following year you owe $110 plus 10 percent of $110, or $121.

The question, “What are interest rates?” is relevant for savings too. When you deposit money in a savings account, the interest rate is the money the bank pays you for allowing it to hold your savings. For example, if you put $100 in an account that pays 3 percent interest compounded annually and leave it there for five years, at the end of that period, you will have $115.93 in the account.

Smart consumers pay attention to interest rates when they make financial decisions. Here are some guidelines to follow.

Maintain a Good Credit Score so You Will Qualify for Low Rates

Because interest rates are the price you pay for loans, you want to qualify for low interest rates. To do that, you need a good credit score. Paying your bills on time and making sure your credit usage is well below your limit will improve your score.

Pay Off High-Interest Loans First

If your loans charge different interest rates, some of them are more expensive to you than others. Pay off the high-interest loans first to save money in the long term. Debt payment plans that do not take interest rates into account, such as plans that encourage you to pay off small loans before larger ones, hurt you financially because they allow interest to pile up. This causes you to pay more in the end.

Maximize the Interest You Earn on Savings

You want to avoid paying high interest rates when you borrow money, but interest rates work in your favor when you save. Thus, you should choose a savings account or certificate of deposit that pays a high rate of interest and that compounds the interest frequently. It is important to avoid letting money sit in accounts that do not earn interest such as checking accounts or online shopping accounts. If you have money in one of these accounts and you do not need it right away, transfer it to an interest-earning account so your wealth can grow. In addition, you want to start saving for large expenses as early as possible so your savings have more time to accrue interest.

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