An interest rate is the percentage of borrowed money charged annually as the cost of borrowing. A 5% interest rate on a $10,000 loan costs $500/year.
How It Works
Borrow: $10,000 Interest rate: 5% APR Annual interest cost: $10,000 × 0.05 = $500
On a 30-year mortgage, that $500 annual cost compounds through each year as you're paying interest on remaining balance.
APR vs. APY
APR (Annual Percentage Rate): The stated rate (5%)
APY (Annual Percentage Yield): Includes compounding effects. If interest compounds monthly at 5% APR, the APY is slightly higher (5.12%)
For savings accounts, APY is higher than APR. For loans, APR is what you pay.
What Determines Rates
- Credit score: 750+ score might get 6% while 650 score gets 7.5%
- Economic conditions: Fed raises rates → lender rates increase
- Loan type: Mortgages typically lower than credit cards
- Loan term: 30-year mortgages typically lower than 15-year
- Market competition: Multiple lenders competing drive rates down
Impact on Total Cost
Borrow: $300,000 mortgage Rate A: 6.5% = $1,896/month = $682,560 total interest Rate B: 7.5% = $2,098/month = $754,560 total interest
One percentage point difference: $72,000 total cost
Improving your credit score by 100 points to qualify for a lower rate can save tens of thousands.
Variable vs. Fixed
Fixed rate: Stays the same for loan duration. Predictable payments.
Variable rate: Changes based on market conditions. Initial rate lower but can spike.
Most mortgages are fixed. Adjustable-rate mortgages (ARMs) start low but reset higher.
