How Do Interest Rates Work?

An interest rate is the cost of borrowing money. A borrower pays interest for the ability to spend money now, rather than wait until he's saved the same amount. Interest rates are expressed as an annual percentage of the total amount borrowed, also known as the principle For example, if you borrow $100 at an annual interest rate of five percent, at the end of the year you'll owe $105.

Interest rates aren't just random amounts you pay for the privilege of borrowing money. The interest a lender receives is his compensation for taking a risk. So really it largely depends on the risk being taken. (though there are cases where Government mandates or the FED can artificially manipulate this risk formula)

The general rule is that with every loan, there's a risk that the borrower won't be able to pay it back. The higher the risk that the borrower will default is, the higher the interest rate will be. That's why maintaining a good credit score will help lower the interest rates offered to you by lenders. For more information see What is a Good FICO Score Range.

The nice thing is that interest rates work both ways. Banks, governments and other large financial institutions need cash, too, and they're willing to pay for it. If you put money into a savings account at a bank, the bank will pay you interest for the temporary use of that money. Governments sell bonds and other securities for the same reason, they need cash. In this case, you're the lender, and the interest rate is your compensation for temporarily giving up the ability to spend your cash.

Unfortunately, savings accounts and government-issued bonds pay relatively low interest rates because the risk of defaulting is close to zero. Governments don’t default on loans, they simply print more money to pay it off even if they inflated money supply will make every unit of currency worth less down the road. Without getting too political, just know that the Government has to deal with interest on its loans just like the rest of us. The difference is that they can keep raising the limit on their own credit card (unlike the rest of us) and money really DOES grow on trees for them. For the most part, foreign countries and other financial institutions continue to buy U.S.Government backed securities NOT because they think the Government is good for it, but because they think the American people are good for it. It is the ability of the Government to tax its citizens that covers the “risk” of the debt that the Government continually borrows.

A borrower's credit score is only one of the risk factors that affect interest rates. For example, interest rates for unsecured credit will always be higher than secured credit. Secured credit is backed by collateral. A mortgage is the classic example of secured credit, because if the borrower defaults on the loan, the bank can always take the house. Credit cards are unsecured credit, because there's no collateral backing the loan, only the cardholder's credit score. Mortgage interest rates are typically much lower than credit card interest rates because they're less risky for the lender.

In most cases Long-term loans carry higher interest rates than short-term loans, because the more time a borrower has to pay back a loan, the more time there is for things to go rotten financially, causing the borrower to default. The exception might be hard money loans where a borrower needs access to capital for a short period of time and is willing to pay a higher rate to borrow that money because the loan to asset value is high (like buying distressed and undervalued homes). Many people who use hard money loans are willing to pay 10-20% on the money being used for as little as 60 days, if they feel they will make 40% on the investment during that time by already having a buyer for the property lined up.

Another factor that makes long-term loans less attractive to lenders -- and therefore raises long-term interest rates -- is inflation. Because of our monetary structure that includes fractional reserve banking (money not backed by gold), inflation almost always rises, meaning the same dollar amount today is worth less five years from now. Lenders know that the longer it takes the borrower to pay back a loan, the less that money is going to be worth.

That's why interest rates are actually calculated as two different values: the nominal rate and the real rate. The nominal rate is the interest rate set by the lending institution. The real rate is the nominal rate minus the rate of inflation. For example, if you take out a mortgage with a nominal interest rate of 10 percent, but the annual rate of inflation is four percent, then the bank is only really collecting six percent on the loan.