What Is an Interest Rate?

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Written by: Guest | Best Company Editorial Team

Last Updated: November 1st, 2019

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No matter what type of loan or source of credit you are seeking to secure-be it a mortgage, auto loan, student loan, credit card or personal loan-there are certain components you examine and pay attention to.

Clearly, the amount you are financing or the limit you are given is of primary concern. The term, or amount of time you have to pay back the loan, will be important as well. But the interest rate will catch your attention just about as much as anything else.

Interest rate can be defined as the amount a lender charges in addition to the principal that the borrower pays with the loan. It is expressed by a percentage in annual terms. Simply, an interest rate is charged so the lender can make money off of your loan. Without an interest rate (in addition to other fees assessed), your lender will merely break even on the deal.

It is important to understand that interest rates can be very volatile. These rates have a tendency to fluctuate considerably. Though economists and financial experts can use market conditions, trends and other factors to predict how rates will rise and fall, and to what degree this will happen, it can be very difficult to gauge where interest rates will stand from period to period.

Similarly, interest rates vary depending on the loan type. For instance, your mortgage loan interest rate will be much lower than the rate on your credit card or personal loan. An auto loan rate will generally be lower than a mortgage loan rate. For comparison sake, here is a look at the U.S. national average on various loan types, as of Nov. 12, 2015:

  • Mortgage, 30-year fixed: 4.11% (source: Bankrate.com)
  • Mortgage, 15-year fixed: 3.85%: (source: Bankrate.com)
  • Auto, 48-month new: 3.14%: (source: Bankrate.com)
  • Federal Stafford student loans, undergraduate: 3.86% (source: staffordloan.com)
  • Federal Stafford student loans, graduate: 5.41% (source: staffordloan.com)
  • Rewards credit cards: 15.09% (source: Bankrate.com)

There a few reasons for these differences between loan types. First of all, with mortgages and automobiles, the rates are typically lower because these are secured debts. This means the person receiving the loan is putting up collateral (in the form of the home or car) and providing security for the lender in the event a person cannot or will not comply with the terms and conditions of the loan. Conversely, with credit cards, personal loans and student loans, which are unsecured loans, the lender charges a higher rate in an effort to protect against default. Since an asset cannot be taken away due to failure to pay-because no such asset was used as collateral-the lender charges a higher rate to ensure greater return.

Lenders may also consider one's credit score when determining interest rates. The better one's credit score, the lower the rate will be. Applicants with lower credit scores are a bigger risk and pose a greater likelihood of not paying back the loan, so lenders will increase the rate.

If you are looking for a loan or any form of credit, it's wise to shop around for the best rates. This will ensure that you pay less over the life of the loan on top of the principal. In this same vein, it's critical to have a healthy credit score and credit history to ensure your rates are more favorable.

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