What Is Interest?
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
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
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
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—or 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
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?
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 four percent. 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, and 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
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 percent 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.