Written by Anza Goodbar (last updated November 22, 2011)
Simply put, interest rates are the cost of borrowing money. In order to lend money, the lender must set aside funds for someone else's use. Interest is the amount of money agreed upon to pay back the loan. Borrowing money allows for purchases to be made now and paid for over time. Interest rates are tied to the risk factor a lender has in making the loan, the longer your credit history and the higher your score, the lower the interest rate. Interest is the revenue companies get for lending their product, or money.
Interest is also the money paid to you on money you deposit at a financial institution. Simple interest is typically paid on a basic savings account. Simple interest can be calculated by multiplying the principal times the interest rate times the time period the interest is to be paid. For example if you took out a loan for $100 at 5% interest with intent of paying it back in year, you would multiply 100 x .05 x 1 for a total of $5.
Some types of interest compound over time. This simply means that you make interest on your interest, not just the principal amount you deposited. In general you will make more money on funds that are compounded more frequently. The APY or annual percentage yield shows you what you are actually making on your money. If you are purchasing a CD, and they both pay the same interest, see which one pays out interest most often, it will be the better choice for you. The calculation for APY on investments can be tricky, talk to your financial advisor for more detailed information.
When shopping for a loan, know your credit score. That is your bargaining chip for getting the best rate possible. As you can see, the higher the interest rate, the more costly it is to borrow money. The lower your credit scores the higher risk you are to a lending institution. Over the course of a 30 year mortgage a higher interest rate could cost tens of thousands of dollars.
Just as a lending institution wants to make as much money from a financial transaction, you should be equally savvy when looking for interest rates paid out to you for deposits and CDs. Interest rates can make you money as a depositor or cost you money as a borrower.
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