What is interest?
Interest is either what it costs to borrow funds or the profit you earn on funds deposited in interest-bearing accounts, such as savings accounts. For loans, interest is paid by the borrower to the lender. For deposit accounts or investments, interest is received by the account holder or investor.
Interest is calculated as a percentage of the loan (or deposit) balance, paid to the lender periodically for the privilege of using their money. The amount is usually quoted as an annual percentage rate (APR), but interest can be calculated for longer or shorter periods, too. If you’re taking out a loan, interest must be repaid in addition to the principal.
The actual amount you’ll pay or receive is expressed as the APR, which is often different from the interest rate because the APR includes other costs and fees associated with the loan.
Simple interest vs. compound interest
Simple interest, also called flat-rate interest, is just the percent paid on the principal or percent of a deposit paid. Simple interest is calculated only on the original amount, whether it be a loan or deposit. Compound interest calculates interest on both the principal and any interest due.
Regardless of how long your money is in the bank, with simple interest you’ll only make money on the initial amount deposited. Same for a loan: No matter how long it takes you to pay it back, you’ll only be charged interest on the principal amount. Compound interest is famously known as “interest-on-interest.” That’s because the interest charged is added to the principal amount and interest is calculated on the total due.
Example of simple vs. compound interest
Let’s say you have $10,000 deposited in an account that pays simple interest. The annual interest rate is 10%. With simple interest, you’d receive $1,000 a year in interest payments, with $13,000 in your account after three years.
Compound interest allows you to earn money on your money. With the same example above, your $10,000 would be worth $13,481 after three years if interest was compounded. That’s because your $1,000 a year in interest also earns interest.
How interest rates are determined
In the United States, the Federal Reserve—also known as the “Fed”—sets interest rates. The Fed is a central bank, which use interest rates as a form of monetary policy in order to create stability and liquidity in the financial system.
The Fed manages short-term interest rates via the Federal discount rate, which dictates how much the government charges banks to borrow. The discount rate affects many key rates, including the prime rate—the rate that banks charge their best customers.
Long-term rates, such as auto loans and mortgages, are more directly affected by the long-term Treasury yields, such as the 30-year Treasury note. Keep in mind that the discount rate can affect Treasury notes, too: A lower rate spurs demand for Treasury notes, and the increased demand forces Treasury yields lower.
Types of interest
Beyond simple and compound interest, there is also fixed and variable interest. A fixed interest rate does not change—many mortgages are fixed-rate loans. However, some loans (including mortgages) have variable rates, which fluctuate.
These variable rates, such as those charged by adjustable-rate mortgages, will change in tune with the prime rate. These loans can be beneficial for borrowers if rates fall, but can lead to higher payments if rates increase. Deciding if adjustable-rate or fixed-rate mortgages are right for you often comes down to risk aversion. Adjustable-rate mortgages can be great deals if you’re savvy and willing to take on a little risk.
How does mortgage interest work?
One of the most common types of mortgage interest rate is the 30-year fixed rate. Shorter terms have lower interest rates—for example, the 15-year fixed rate might be 0.5% lower than the 30-year rate.
For a mortgage, interest is calculated monthly. Part of your payment is applied to the principal—or the initial amount of the loan—and the rest goes toward interest. As the principal amount is reduced, interest decreases, too. That means more of your payment will go directly toward the principal. This is known as amortized interest, and is popular for home and auto loans.
For example, Leanne is buying a property for $250,000. She puts $50,000 down and gets a 30-year, fixed-rate loan for $200,000 with an interest rate of 4%. Her monthly payment will be $954.
On the first payment date, interest accounts for $666.67 of the $954 payment. Although the interest rate doesn’t change, after five years, only about $600 of her payment will go toward interest. That amount will continue to steadily decline over time as the amount being applied to the principal balance increases.
Interest rates and real estate investing
The easiest way to eliminate interest rates is to pay all cash. However, that might not be financially possible—nor does it necessarily make sense for someone trying to maximize returns.
If a real estate investor has $250,000 to invest, using debt to purchase several properties may be a smarter bet than spending all that cash on one property. Leveraging your properties through mortgages can boost the potential returns. One note: By historical standards, current interest rates are at historical lows, so financing a home with debt can be particularly advantageous in the current economic environment.
Interest rates are especially important for investors, especially if financing a property. For a $500,000 loan, the difference between a 3.5% and 5.5% rate is more than $43,000. And more broadly, investors need to pay attention to rates because they can dramatically affect the broader real estate market. Higher interest rates can hamper demand, while lower rates can boost markets and the demand for real estate, driving values higher. For instance, low rates can help you leverage a home you already own to purchase more property.
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