5 Things You Need to Know to Understand Your Interest Rates

interest ratesInterest rates determine what your monthly repayments will be on your loan. Even the smallest fluctuation in interest rates can make an enormous difference to your loan repayments. Each interest rate comes with advantages and disadvantages, so make sure you select the right interest rate for you. Lenders will charge you an interest rate per annum which is calculated on your outstanding balance of the loan, how many days there are in the month and what the Federal Reserve Bank prime rate is for the month.

Types of interest rates

Finding your way through the complex expanse of interest rates can be mentally draining. There is a variable rate loan where the interest rate fluctuates. There are usually no restrictions in making extra repayments with a variable interest rate. A fixed rate will lock the interest rate in for between 1 to 5 years, but this can be negotiated with the lender. If interest rates fall, you will still pay the higher rate but if interest rates go up, you will pay the lower fixed rate.

Nominal Interest Rate

Nominal interest is the stated interest rate on a mortgage or debt instrument such as a bond and this is the cost to the borrower.  For instance, if the nominal interest rate on a loan is 8.5%, then a borrower will pay $8.5 in interest for every $100 borrowed.

Real Interest Rate

Real interest rate is more useful in determining the actual rate of return on a loan or investment because it takes inflation into account.  Inflation has the effect of eroding the value of assets over time so that $1 today is worth less in the future.  For instance, if the annual rate of inflation is 3%, $1 would be worth approximately 97 cents one year from now. Further, if a bond had a 4% nominal rate and inflation was 3%, the real interest rate would be 1%.

Effective Interest Rate

Another type of interest rate borrowers and investors should be familiar with is the effective interest rate, which accounts for the compounding of interest or the time value of money.  For example, if a $10,000 investment pays 5% annually and compounds semi-annually, then the investor will receive $250 after 6 months ($10,000 x .025), and $256.25 after the next 6 months ($10,500 x .025).  The investor would receive a total of $1025 in interest payments the first year so even thought the nominal rate was 5% the effective interest rate was 5.06%.  As you can see from this example the effective interest rate will continue to increase over the life of the investment.


Compare Rates & Know Your State Usury Laws

One of the best methods of comparing rates is to use a financial calculator to help compare different interest rate scenarios. These calculators are available on the websites of all banks and home loan lenders, so shop around. Make sure to look at not only the interest rates, but the fees and charges that come with each interest rate. Comparison rates will give you the interest rate plus all associated fees that come with the loan. Lenders may not introduce new fees during the term of the loan, so it is important to factor this in when comparing interest rates.

Credit card companies are limited by state usury laws however many companies get around this by chartering in states like Delaware or South Dakota that have very liberal usury laws.  Limits on payday type loans vary widely by state with Montana and New Hampshire having some of the highest rates at 36%.   Interest rate limits on other types loans vary however, most states allow exceptions if the rate is agreed to in writing. For instance Iowa limits rates to no more than 5% unless another rate is agreed to in writing.

By obtaining the best deal on interest rates, you can save thousands of dollars. A loan is a big commitment and it is crucial that you understand the interest rates and fees you will be charged.

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