How Do Interest Rates Work?
If you’re buying your first home or getting ready to invest in securities for the first time, you probably have a lot of questions. The first and most important should be: “how do interest rates work?” This is an invaluable first question to ask because it’ll govern how you look at your investment—whether you’re taking on new debt or calculating ROI.
The fact is, interest rates are the defining variable controlling investments. Even more important than time, interest rates dictate what you can expect to gain from an equity or owe to a debt. But they’re not just a number—they have meaning and purpose. Understanding how interest rates work is your secret to maximizing your choices when it comes to investing. Here’s what you should know about this all-important governing factor.
What is an Interest Rate?
An interest rate is a percentage of the principal value that’s owed in regular intervals for the term of the investment. It’s the cost of borrowing money. Or, if you’re the creditor, it’s your rate of return. An interest rate is what makes lending money lucrative and it’s a way of determining the cost of borrowing before you decide to take a loan. Here’s a simple example:
Marybeth is buying a rental property. Her mortgage is for $260,000, with an interest rate of 3.15% over 30 years. In addition to paying off the balance of her property, she’ll pay an additional $139,687.35 over the life of the loan.
Interest rates can be fixed or variable, and can come with different compounding rates. For example, your stock market investments might have a variable rate of return each year. Conversely, your credit card debt may compound daily at a fixed rate. The interest rate, compounding frequency and term all depend on the financial vehicle.
Fixed vs. Variable Interest Rates
There’s special significance in understanding fixed vs. variable interest rates. One is predictable; the other isn’t. In some situations, one is preferable over the other. Here’s a look at what makes them different.
- Fixed interest rates. Fixed interest rates don’t change over time. They’re agreed upon at the outset of an investment. For example, if you take out a 30-year mortgage with a 3.25% fixed interest rate, that rate will remain the same for the next 30 years, through the term of your loan. The same goes for a fixed-rate bond and similar investment vehicles.
- Variable interest rates. Variable interest rates are subject to fluctuations dependent on market forces. Rates tend to be lower during times of economic hardship and higher during stable periods, to encourage borrowers. These are sometimes called adjustable or floating rates, and can range several percentages over the term of the investment.
There are also annual percentage rates (APRs), which typically involve credit purchases. This is interest expressed annually on the total cost of the loan.
Typically, variable interest rates assume more risk, but have the potential to be lower (or higher) than the average prime rate at the time of agreement. Conversely, fixed rates are stable and predictable, but aren’t always prime.
An interest rate becomes a powerful tool when compounding comes into the mix. If you choose to reinvest interest payments back into the principal balance, that balance is able to generate higher interest payments. This continuous reinvestment cycle greats exponential growth—even if the interest rate remains unchanged. This is how most investments accumulate wealth over time, regardless of if the rate of return is a fixed or variable percentage.
To see the power of compound interest at work, check out our investment calculator. You’ll have the ability to plug-and-play different variables to get a better understanding of how compound interest exponentially grows an investment.
The Relationship Between Principal and Interest Rate
Interest rates by themselves are just numbers. They only become powerful when you pair them with a principal amount. Then, you’ve got the missing part of the equation for what you’ll earn or owe, depending on whether you’re investing or borrowing.
Take a look at a few examples of how principal and interest rate play off of each other over a 30-year period:
- A compound rate of 5% on an investment of $10,000 is $44,683
- A compound rate of 5% on an investment of $20,000 is $89,349
- Compound rate of 10% on an investment of $10,000 is $198,389
- Compound rate of 10% on an investment of $20,000 is $396,746
As you can see, the higher the interest rate, the more powerful the compounding is. Likewise, the higher the investment amount, the larger the accumulation opportunity. Interest rate has more power when it comes to compounding, but without a principal investment, it takes longer to ramp up.
Interest Rates Affect How You Spend and Save
How do interest rates work? When you understand them, interest rates become the secret to unlocking tremendous wealth potential. You can use this knowledge to get out of debt by undercutting compounding balances. Or, you can funnel investments into higher-yield vehicles to take advantage of compound interest. It all starts with a fundamental understanding of how interest rates impact you.
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As you consider what to do with your debt or investment income, pay attention to interest rates. Look for low rates if you’re borrowing; seek out strong rates if you’re lending. Do what you can to maximize the power of interest as it pertains to your situation. While less-informed investors focus on principal, you can focus on interest and get the results you want quicker.