Understanding Interest Rates

The plain answer

Interest is the price of borrowed money. An interest rate expresses that price as a percentage of the amount you owe.

A higher rate generally means borrowing costs more. A lower rate generally means it costs less, but fees, the loan term, and how the lender calculates interest also affect the final cost. For a broader yearly cost measure, see APR Explained.

How it actually works

Lenders apply an interest rate to your balance. Depending on the product, interest may accrue daily, monthly, or on another schedule. Payments typically cover accrued interest first, then reduce principal, which is the amount you borrowed.

Rates can be fixed or variable. A fixed rate stays the same under the loan agreement. A variable rate can change when its benchmark changes, so future payments or interest charges may rise or fall.

The rate is only part of the cost. The balance, repayment term, payment schedule, fees, and whether interest compounds all matter. Two loans with the same rate can have different total costs if their terms differ.

What this means for you

Compare offers using the rate, APR, required payment, fees, term, and total amount repaid. If you carry a balance, paying more than the minimum can reduce the time interest has to accrue.

When deciding which debt to pay first, the highest interest rate is an important signal. It is not the only consideration, since missed payment consequences, tax treatment, and access to cash can also affect the decision.

Common mistakes

• Comparing monthly payments without comparing loan terms or total repayment.
• Treating a variable rate as if it cannot change.
• Assuming the stated interest rate includes every fee.
• Focusing on the original loan amount instead of the current balance and payoff terms.
• Paying late and triggering fees or a penalty rate.

Related pages

• APR Explained
• Good Debt, Bad Debt, and Necessary Debt
• The Order of Operations for Your Money
• Paying Down Debt