Interest rates are spoken about a lot in the finance world. Whether you’re looking to borrow money from a lender or invest it, you’ll need to know about interest rates.
If you have a vague idea, then this guide will help solidify your knowledge and bring some sense to the little bits and pieces you’re unsure about. If you have no clue where to begin, then this will be the perfect place to start!
What are interest rates?
The technical definition is that interest rates are a percentage charged on the overall amount of money that you borrow or save.
So, when you borrow money from a bank, the interest rate is a percentage of the total loan that you need to pay back to them.
But, when you save money, you’re also given an interest rate. Here, it’s a percentage of your savings that gets paid back to you. This is because the bank essentially borrows money from you when you deposit it into an account. We won’t get into the technicalities of that – it’s a whole other topic for a different day!
Typically, rates are expressed as APR – the annual percentage rate. For example, you might want a bank loan for $10,000 that has an APR of 5%. This means that you pay 5% of that loan every year as interest. So, you can now calculate that you’ll pay £500 in interest, every year until you’ve paid back the loan in full.
It can be confusing, but once you start seeing interest rates in the real world, you soon get the hang of what they are and how they work.
Why do interest rates matter?
Interest rates are hugely significant in just about everything to do with finance. Whenever you want to borrow money – be it a loan, mortgage, or even a credit card – there will be rates. Realistically, they’re in place so lenders can actually make money. If they didn’t charge any interest, then they’d just be lending money out to everyone for free.
So, you need to understand and be wary about interest rates if you want to borrow money at any point in your life. It’s always a smart idea to shop around before you apply for any credit cards or look for any loans/mortgages. In an ideal world, you want to borrow money from a lender with the lowest interest rate. As such, this would mean you have to pay less money.
As touched upon earlier, rates are also vital if you want to save or invest money. Savings accounts have interest rates to help grow your investment. Each year, you can add a percentage of your savings to your account balance.
The best thing is, you don’t have to lift a finger or do anything. Ironically, in this scenario, you should shop around for a savings account with the absolute highest rates, so you can earn as much money as possible.
Financial institutions often have a range of products for you to choose from if you’re looking to invest or save your money. Standard savings accounts are available, but the interest is really bad on them. Then, you have things like a high interest term deposit that offers far more generous rates, but with more restrictions. It’s a case of weighing up the different options and choosing the one that speaks to your requirements while offering a decent interest rate.
As a summary, interest rates matter because they determine how much it will cost to borrow money, or how much money you can gain from saving/investing it.
Does your credit score affect rates?
Yes, it does. Your credit score is basically a figure that helps show how creditworthy you are. It’s pretty much a nice and simple way for lenders to look at you and figure out if you’re trustworthy or not to be granted credit.
In some cases, a bad credit score can mean you don’t get your application accepted at all. But, there’s a general rule that poor credit scores will result in worse interest rates.
Now, banks and lenders will usually advertise a specific interest rate for their different products. This will be the best interest rate you can get, but not everyone will end up with it. Usually, you need to have a good credit score to qualify for the advertised rate – often referred to as the representative APR.
But, if your score isn’t up to scratch, then the bank will give you a higher interest rate, which means it costs more for you to borrow money. They do this because people with bad credit scores aren’t seen as trustworthy as ones with good ones. It’s more of a risk for lenders, so they compensate for this with higher rates.
The good news is that your credit score doesn’t impact the interest rate on savings accounts or other investment products!
Are there different types of interest rates?
There are many types of interest rates out there, but the two you need to concern yourself with are:
- Fixed interest rates
- Variable interest rates
A fixed interest rate is one that will stay the same forever. So, if your mortgage has a 2.5% fixed interest, you will pay that amount every year until your debt is paid.
A variable interest rate may start out with a fixed term, but it will then be open to fluctuations. This means it could go up, or it could go down. So, you might end up paying less, or you could end up paying more – it all depends on the rate.
It’s crucial that you start understanding interest rates if you want to make good financial decisions! Shop around whenever you borrow money; look for lenders with the most favorable rates, so you pay as little as possible.
If you’re opening savings accounts, then look for the best rates so you can earn more each year! Also, make sure you keep your credit score in check. If you don’t, then you can end up on lousy interest rates when borrowing money.