What is an interest rate? (with photos)

The interest rate charged on a credit card is expressed as an annual percentage rate.

Those in the money lending business have the legal right to charge borrowers an additional fee for their services. For example, if Jim borrows $100 US dollars (USD) from Jeff, that money would be considered the “principal” amount of the loan. Jeff can ask Jim to pay back the principal plus $10, which would be considered an “interest” payment. When dividing the interest amount of $10 USD by the principal amount of $100 USD, the result is a percentage called the interest rate. In this case, 10 divided by 100 results in an interest rate of 10%.

Interest is charged at a fixed or flexible rate on the money borrowed until the debt is paid off.

The interest rate on a loan is usually calculated as an annual amount, even if the terms of the loan require a different repayment schedule. Vehicle loans are often advertised as having an annual percentage rate (APR) of 2.9%, even though the actual payments are spread over 5 years. This rate indicates that for every $1,000 borrowed toward the price of the car, the lender will receive an additional $29 in interest payments. This amount is added to the borrower’s monthly installments.

Lenders charge borrowers interest for using the funds.

An interest rate expressed as an annual percentage can help determine whether a particular lender’s terms are reasonable. Payroll lenders, for example, may charge a flat fee for a short-term loan due upon receipt of the borrower’s next paycheck. Expressed as a surcharge, this interest payment may not seem excessive; maybe a $50 interest payment on a $250 emergency loan. But calculated as an annual interest rate, the result is a relatively high 20% APR. Some short-term loans have an annual fee of 150% or more if the loan is not fully repaid and interest accrues daily or monthly.

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The Federal Reserve Board adjusts certain interest rates.

Loans can have a “flexible” or “fixed” interest rate. A fixed rate means that the lender can only charge the same amount of interest per month for the life of the loan. Many borrowers prefer to find a lender that offers a fixed interest rate because the repayment terms are predictable and protected by a contract. Since the rate cannot be adjusted, however, many lenders either charge more for loans or do not offer them at all. When purchasing a big ticket item such as a house, a fixed interest rate is almost always preferable to a flexible one.

In the case of a flexible interest rate, lenders often tie the loan interest to current federal borrowing rates, also known as the prime lending rate. This is the fee charged by the federal government to major banks and other lending institutions. The prime rate is regularly adjusted by the chairman of the Federal Reserve Board, based on economic factors such as inflation or high unemployment. Lenders may legally charge borrowers an interest rate a few points above the prime rate at the time of the initial loan. If the rate changes, the interest on the loan can also be adjusted. A flexible rate can be beneficial when the economy is healthy, but it can be more expensive if rates are suddenly increased.

Consumers should understand how an interest rate is calculated before applying for store credit cards and other billing accounts. Credit card companies routinely promote lower introductory rates to attract new customers, but the standard rate on many cards is 21% or more.

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