Understanding Interest Rates: What Your Bank Wants You To Know

Over the last couple of years, interest rates have fluctuated quite a bit. After plummeting to record lows in 2020, they made a steep climb back. As you navigate the changing interest rate climate, it helps to understand how interest rates impact your finances.

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Here’s what banks want you to know about interest rates.

The Federal Reserve Impacts Interest Rates in a Big Way

The Federal Reserve (the Fed) sets the federal funds rate, which is the rate banks use when loaning money to other banks overnight. When the Fed changes the federal funds rate, this impacts interest rates across loans and deposit products.

For example, when the Federal Reserve lowered the federal funds target interest rate to between 0.00% and 0.25% in March 2020, that led to historically low mortgage rates.

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Many Other Factors Impact Your Interest Rates

Although the federal funds rate is an important factor in determining your interest rate for a particular loan or deposit product, it’s far from the only factor considered. Banks and lenders take many other details into consideration when determining rates.

For example, say you wanted to take out an auto loan. In addition to the interest rate environment, other factors the lender might consider when determining your loan’s rate may include:

• Your credit score

• Your income

• Your other debts

• The size of the loan

• The loan term

• The size of your down payment

• The type of vehicle you are purchasing

As you can see, there are many factors at play in determining your interest rates. But your credit score is an especially important factor for most lenders.

For example, an Experian study found that in the second quarter of 2024, the average APR for an auto loan borrower with a credit score of 781 to 850 was 5.25% for a new car. In contrast, borrowers with a credit score between 601 and 660 received an average APR of 9.83%. Taking the time to improve your credit score might help you tap into a lower interest rate.

APRs and APYs

When it comes to interest rates, the discussion wouldn’t be complete without defining APRs and APYs.

An annual percentage rate (APR) represents the total cost you’ll pay each year for borrowing. The percentage encompasses the interest rate attached to the loan and other fees involved in getting and maintaining the loan. A higher APR means you’ll pay more for the loan overall.

An annual percentage yield (APY) represents how much you can earn from a deposit product — like a savings account — in a single year. The percentage takes the interest rate and the frequency of compounding into account.

When comparing products, it’s often easiest to compare APRs or APYs instead of interest rates alone. The APR and APY metrics give you some insight into the total costs or benefits of the product without having to dive into the fees or compounding frequency of each product you compare.

Not All Interest Rates Are the Same

Interest rates come in many flavors, each of which has an impact on your finances. Here’s a closer look at the key types of interest rates to consider:

Simple Interest

Simple interest is calculated on an annual basis. You can determine the simple interest rate by multiplying the principal by the interest rate by the time.

For example, say you took out a loan for $10,000 for three years with a 4% interest rate. In this case, you would owe $1,200 in total interest over the loan term.

Compound Interest

Compound interest involves earning interest on the interest you’ve already earned. For borrowers, compound interest can make it harder to get out of debt. But for savers, compound interest allows their funds to grow faster.

Say you took out a loan for $10,000 for three years with a 4% interest rate. With interest compounding monthly, you’ll owe $1,272.72 in total interest over the loan term.

Variable Interest Rates

Variable interest rates can change over the life of the loan. As the market conditions change, you can expect a variable interest rate to change, as well. Ultimately, variable interest rates tend to produce a changing monthly payment, which can be difficult to budget for.

Fixed Interest Rates

Fixed interest rates cannot change over the life of the loan. Generally, fixed interest rates produce standard monthly payments that are easier to plan for.

Interests Rate Can Help or Hurt Your Finances

Interest rates can have a big impact on your financial situation. When building wealth, consider using the following strategies to maximize the positive impact or minimize the negative impact of interest rates.

When You Are Borrowing Money

Borrowers should expect to pay interest on the funds they borrow. But keeping a close eye on the details can help you avoid overpaying in interest charges. Here’s what to keep in mind.

• Shop around for the right lender. Different lenders offer different interest rates. Don’t be afraid to compare quotes across multiple banks to find the cheapest rate for your situation.

• Beef up your credit score. A higher credit score can translate into lower interest rates. Stay committed to on-time payments and clear mistakes off your credit report to potentially see your score rise over time.

• Avoid high-interest debt. Although it’s tempting to put everything on a credit card, these typically come with relatively high interest rates attached. Do your best to avoid growing a balance with a high interest rate, because it can be difficult to pay down.

When You Are Saving Money

Savers looking to grow their funds can turn to deposit products. Here’s how to push your dollars the furthest.

• Put your emergency fund to work. Many experts recommend stashing between three to six months of living expenses in an emergency fund. If possible, tuck those funds into a high-yield savings account to earn interest on your funds.

• Consider other deposit products. Although it may be tempting to put all of your funds into a high-yield savings account to keep it accessible, consider putting some of your funds into a certificate of deposit (CD). The timed deposit accounts sometimes offer higher interest rates for the long term.

• Don’t be afraid to switch banks. Some banks offer abysmal rates, while other banks offer accounts with interest rates to help you move the needle. Compare your options and don’t be afraid to make a change to lock in a better return on your funds.

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This article originally appeared on GOBankingRates.com: Understanding Interest Rates: What Your Bank Wants You To Know