Whether you plan on applying for a credit card, mortgage, or personal loan, it will be helpful to understand how the interest rate associated with the loan works and what it will ultimately cost you. Read on to learn how loan interest rates work and some facts you should know about them:

How loan interest rates work

Interest is the cost you pay to borrow money and how lenders earn the majority of their revenue. Depending on the structure of the loan, the interest rate may be fixed and integrated into your payments. Alternatively, it might also be a variable rate that fluctuates over time. To avoid unnecessary interest charges, the borrower should understand the conditions of the loan and meet these terms.

5 facts about loan interest rates

Whether you're borrowing money for the first time or have already had multiple loans over the years, here are five facts about interest rates that you may not know:

1. You might be paying the interest upfront

Depending on the type of loan, your initial payments might be more interest than principal. Mortgages are designed to do this so that the lender gets paid their interest sooner. It's important to know this because you may be making regular payments for years but not building as much equity in your home as you thought.

2. Interest rates are tied to the Federal Reserve

Lenders don't arbitrarily set their interest rates. Most come from something called the prime rate, or an interest rate that is used internally by the banking industry and serves as the foundation for the interest rates of all other products.

The prime rate used by banks is closely tied to the federal funds rate set by the U.S. Federal Reserve. This means that when the news reports that the Fed wishes to lower or raise interest rates, you can expect the rates of loans and credit cards to follow.

3. Your credit score affects your interest rate

When you see a lender advertise an interest rate, this is usually reserved for applicants with higher credit scores. People with lower credit scores may still qualify for the loan, but they will be offered a higher interest rate.

4. Interest rates can be negotiable

Interest rates aren't always set in stone. If there is another lender that's advertising better interest rates, then you may be able to negotiate a better deal. Other factors, such as your income or other readily available assets, could also be leveraged to your advantage.

5. The rate that interest compounds matters

While getting a low-interest loan is desirable, it's also important to know how often the interest charges will compound. This will make a difference as to how quickly the interest charges can build.

Credit cards are an example of loans where the interest compounds daily. Charges are added to your balance every day, and this is why people who are in excessive credit card debt often struggle to overcome it.

The bottom line

The interest rate on a loan is what you're paying to borrow money. Understanding how the rates are tied to the Federal Reserve, your credit score, and how they're compounded can make a difference in how much you'll ultimately owe the lender.

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Name: Michael Bertini

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