Understanding Interest: A Comprehensive Guide

Interest is a fundamental concept in finance, impacting both borrowing and saving. Whether you’re taking out a loan, using a credit card, or investing your money, understanding how interest works can help you make informed financial decisions. In this blog, we’ll explore the different types of interest, how lenders determine interest rates, and the pros and cons of paying and earning interest. We’ll also provide tips on how to avoid interest charges. For any mortgage service needs, feel free to call O1ne Mortgage at 213-732-3074.

How Does Interest Work?

Interest can be paid or earned in three primary financial situations: borrowing, deposits, and investing. Let’s break down each scenario:

Borrowing

When you take out a loan or use a credit card, lenders charge interest on your balance until you’ve paid off your debt. For loans, interest accrues based on your account’s interest rate, which may be fixed or variable, and your daily balance. Each month, a portion of your payment goes toward the interest that has accrued since your last payment, with the remainder reducing your principal balance (the amount you borrowed).

With credit cards, you can avoid paying interest if you pay your balance in full each month. If you don’t, interest will apply to your unpaid charges. When shopping for a loan or credit card, you’ll typically see an annual percentage rate (APR), which includes both interest and fees, giving you the total cost of borrowing. If there are no extra fees, the APR is the true interest rate.

Deposits

When you deposit money into a savings account, money market account (MMA), or certificate of deposit (CD), you may earn interest on your balance. Savings and money market accounts have variable interest rates that can fluctuate with market conditions, while CD rates are typically fixed for the account’s term. Interest rates on deposit accounts are often expressed as an annual percentage yield (APY), which incorporates compounding and provides a more accurate representation of what you’d earn in a year.

Investing

Certain investments, such as bonds, offer interest payments to their holders. In this case, you’re essentially the lender. Additionally, dividend stocks, real estate investment trusts (REITs), and certain funds can pay income in the form of dividends, which you can reinvest to compound your earnings.

Simple vs. Compound Interest

There are two primary ways financial institutions apply interest: simple and compound interest.

Simple Interest

With simple interest, the interest rate is applied only to the principal balance or investment amount. This type of interest is typically used with installment loans and investments.

Compound Interest

Compound interest accrues based on the principal balance and any interest that’s accrued since the last payment. It’s commonly used for credit cards and deposit accounts. You can also earn compound interest on an investment by reinvesting the interest or dividend income you receive.

Examples

To illustrate the difference, let’s say you have a simple-interest loan with a $10,000 balance and a 12% interest rate. Interest would apply only to the $10,000 balance each day—roughly $3.29 per day—until you make a payment and reduce your balance.

With compound interest, suppose you have a $10,000 balance in a savings account with a 4% interest rate. On the first day, the rate would apply to the $10,000 balance, earning you roughly $1.10 in interest. On the second day, the 4% rate would apply to a balance of $10,001.10 instead of the principal balance of $10,000.

How Do Lenders Determine Interest Rates?

Lenders and deposit institutions use different methods to determine interest rates.

Credit Products

Lenders consider several factors when determining interest rates on credit cards and loans:

• Risk-based pricing: Lenders use risk-based pricing, meaning your interest rate is largely determined by your creditworthiness. They may also consider your loan repayment term, amount borrowed, collateral, down payment, and other elements.
• Market rates: Lenders typically use a benchmark rate, such as the Wall Street Journal prime rate, influenced by the federal funds rate, which the Federal Reserve uses to control inflation. During high inflation, the Fed hikes its interest rate, making borrowing more expensive.
• Lender policies: Each lender has its own approach to determining interest rates based on its financial profile and strategic objectives. Some lenders specializing in borrowers with lower credit scores may charge higher interest rates compared to those with more stringent credit criteria.

Savings Products

Banks and credit unions determine interest rates on their savings products based on several factors:

• Market rates: The federal funds rate directly impacts the rates for many savings products. During high inflation, you’re more likely to find higher rates on high-yield savings accounts, money market accounts, and CDs.
• Other economic factors: Financial institutions use consumer deposits to fund loans, so they may raise interest rates when consumer spending increases to attract more deposits. If consumer spending is down, banks and credit unions may lower their rates.
• Bank policies: Each financial institution has its own approach to determining savings rates based on its financial needs, strategic objectives, and forecasts. Large banks typically offer lower rates compared to small online banks.

Pros and Cons of Paying Interest

Paying interest isn’t always ideal, but there can be benefits to using credit. However, there are also significant drawbacks, especially with high-interest credit products.

Pros

• Financing large purchases: Borrowing money makes it possible for people to obtain housing, transportation, and other important things.
• Leveraging your money: If you can qualify for low-interest loans, you can use that opportunity to leverage your money. For example, if an auto loan’s interest rate is lower than the expected return on a prospective investment, it may make sense to take out the loan and invest the remaining funds.

Cons

• Expensive credit products: If your credit score is low, you may have a hard time qualifying for low interest rates. High rates can put pressure on your budget. Even with great credit, interest rates can vary depending on the product you choose.
• Increasing balances: Making low monthly payments on a high-balance, high-interest account can cause your loan balance to increase over time instead of decrease.

Pros and Cons of Earning Interest

Putting money in a savings or investment account can help you generate a return on your balance, but it isn’t always the most effective way to use your cash.

Pros

• Passive income: You typically don’t have to do anything to earn interest beyond your initial deposit or investment. The more you save and invest, the more you’ll likely earn.
• Additional returns: Investing in income-producing securities, such as dividend stocks, REITs, and funds, can also generate gains through price appreciation.

Cons

• Varied opportunities: Maximizing your interest income can take time and research. It can also be inconvenient, requiring you to switch banks or maintain multiple accounts.
• Risks: Maximizing interest income may require locking up your funds with a CD or taking on investment risks. In some cases, you could even lose some of your principal investment.

How to Avoid Interest Charges

The best way to avoid paying interest is to never borrow money, but that’s not feasible for many people. Here are some steps to minimize your interest costs:

• Establish good credit: Higher credit scores typically correlate with lower interest rates. Check your credit score and report to see where you stand and look for opportunities to improve your credit.
• Avoid unnecessary credit: Try to avoid borrowing money unless absolutely necessary. Save as much as possible for upcoming expenses to minimize borrowing.
• Avoid overborrowing: Minimize the amount of your loan by making a large down payment or choosing a more modest home or vehicle.
• Opt for shorter loan terms: While longer repayment terms can reduce monthly payments, they also typically mean paying more in interest over time.
• Pay credit cards in full: Avoid interest by paying your monthly bill on time and in full during your grace period. Avoid cash advances, which start accruing interest immediately.

Frequently Asked Questions

How Do Lenders Determine Interest Rates?

Lenders consider factors such as risk-based pricing, market rates, and their own policies when determining interest rates on credit cards and loans.

What Is Deferred Interest?

Deferred interest is interest that accrues but is not immediately payable. It is often used in promotional financing offers.

What Is Accrued Interest?

Accrued interest is the interest that has accumulated on a loan or investment but has not yet been paid.

Monitor Your Credit to Maintain Low Interest Rates

Building credit is crucial to qualifying for favorable interest rates. Once you reach a good credit score, it’s important to avoid complacency. Experian’s free credit monitoring service offers alerts when new information is added to your credit report, helping you stay on top of your credit and maintain the results of your hard work.

For any mortgage service needs, call O1ne Mortgage at 213-732-3074. Our team is here to help you navigate the complexities of interest rates and find the best solutions for your financial needs.