Interest is the cost of borrowing money, and an interest rate tells you how quickly those borrowing costs will accumulate over time. For example, if someone gives you a one-year loan with a 10% interest rate, you’d owe them $110 back after 12 months. Interest rates obviously work against you as a borrower. But they benefit you as the lender, such as when you put money in a bank account or certificate of deposit.
That’s what an interest rate is and how it works in its most basic form. But things can get more complicated when you bring in compound interest (i.e. interest on interest). Loans, lines of credit and other financial accounts may also have several different kinds of interest rates. Before we get into introductory rates, penalty rates and the like, however, let’s first get one major distinction out of the way: the difference between interest rate and APR.
Interest Rate vs. APR
You may have heard the terms “interest rate” and “APR” used interchangeably. While they are similar, there are a few key distinctions between the two. APR, or annual percentage rate, is the yearly cost of borrowing. It generally includes interest as well as fees and other charges tacked onto the principal amount you owe.
Some, but not all, loans charge fees. On a mortgage, for example, you might have fees for processing, closing, and mortgage insurance, among other things. The lender then calculates what the payment rate for these fees would be if they were spread evenly across the entire lending period. Then that number gets combined with the interest rate to form the APR. So naturally, if a loan’s APR and interest rate are different, the APR is always higher.
Credit cards are the exception. Their APRs don’t include fees and are just used to calculate daily interest. In addition, some personal loan providers that charge origination fees will include this fee in the APR, while others will not.
Types of Interest Rates
You might come across several different varieties of interest rates, especially on a credit card. Here are some of the most common types of interest rates:
- Regular rate: The interest rate you pay under normal circumstances, when you don’t have a lower promotional rate and you’re making your payments on time.
- Purchase intro rate: This is a temporarily lower rate, often 0%, that you may get for a certain number of months after opening a credit card account.
- Balance transfer rate: When you use a credit card to pay off another credit card or loan, the resulting balance accrues interest at this rate. A so-called balance transfer only makes sense if the card doing the paying has a lower interest rate than the account being paid off. That’s why balance transfer rates are often temporarily lower than normal, sometimes 0%, for a period of time after a balance transfer credit card is opened.
- Penalty rate: This is a higher rate that kicks in if you don’t pay on time. On a credit card, only purchases made after the penalty rate takes effect are subject to higher interest charges at first. But this rate can apply to your entire balance if you become 60 days delinquent on making a minimum payment. You can regain your regular interest rate after paying on time for 6 months; the law requires all issuers to comply with this rule.
- Cash advance rate: If you take out money from an ATM with your credit card, you’ll have to pay a fee and the balance will immediately have a pretty high cash advance interest rate, usually over 20%. Cash advances don’t get a grace period like regular credit card purchases do.
- Annual Percentage Yield (APY): The amount of money you earn on a deposit during one year’s time. It factors in compound interest.
- Prime rate: The interest rate banks charge other banks and large corporations.
- Real interest rate: An interest rate that’s been adjusted for inflation.
Interest Rate Calculations
Calculating the interest charges that you can expect based on your interest rate can be very easy or very complex. It all depends on the terms of the loan or line of credit. To start off, the amount of money you borrow is called the “principal.” You’ll need to pay at least this entire amount back. If you have an interest-free loan, or if you borrow money on a credit card and pay it off by the due date (or within a 0% intro APR period), you won’t owe any more.
If you carry a balance on your credit card or your loan does charge interest, the amount you pay will depend on the length of time you owe the money. It also depends on which of the two major forms of interest applies: simple interest or compound interest.
- Simple interest is the amount you borrowed, multiplied by the interest rate, multiplied by the number of periods during which the issuer charges interest (e.g. 5 if you’re charged by the year and have the loan for 5 years). Periods could be years, months, days, etc. Sadly, most loans don’t make calculations this easy. Most types of interest, including credit card interest, compound over time.
- Compound interest is when interest accrues interest. More specifically, it’s when the interest rate applies to both the principal amount owed and unpaid interest assessed previously. How often that happens is the rate at which interest compounds. An interest rate might compound yearly, monthly, daily, etc. Credit card interest compounds daily.
In conclusion, it’s important to note that some factors that affect interest rates are out of your control. But if your personal credit is excellent, you’re more likely to get a lower interest rate. That means good behavior gives you some leverage.
Also, when you get a credit card, make sure you know what the APR is, and try to always pay off your balance by the due date in order to avoid interest entirely. Daily-compounded interest can really add up.