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[H774]How Interest Rates Work

by Debbie Dragon, Deb

Interest rates are calculated differently based on the type of debt that you have. When trying to determine interest rates on credit cards, it's important to understand what provisions the lender may have for raising your interest rate if you make a late payment. Keep in mind that most credit cards can raise your interest rates even if the payment you made late was on a different credit card!

Understanding interest rates involves understanding a wide range of terms pertaining to interest rates, including:

APR: the annual percentage rate, which is the same rate charged when you borrow the money or charge the purchase on a credit card.

Prime Rate: The prime rate is used to calculate interest rates that are charged to the general public on credit cards and loans. The largest banks set the prime rate and give that rate to the customers who have the strongest credit ratings and the best ability to repay the loans. Some credit card lenders set their interest rates as “prime plus 8 percent”, so if the prime rate was 7.5 percent, then the interest rate charged would be 15.5 percent. If the prime rate changes, the rate charged to the customer changes.

Fixed Rate: interest rates that are considered “fixed” do not change, although they can be increased if you negate on your agreement to make payments on time.

Penalty Rate: Typically, a contract will indicate how much the penalty rate is. A penalty rate is the amount that can be raised in the event that you are late with your payments. Even if you have made all payments on time with a lender, you can still be subject to a penalty rate if the contract indicates a “universal default”. A universal default allows one lender to raise the interest rate when you are late with any other lenders. In some cases, a credit card lender might use the universal default clause to raise your interest rates just because you have excessive debt (even if you've been paying on it regularly) or you've defaulted on a loan.

Variable APR/Variable Rate: interest rates that are considered variable can change, depending on the economy or the fluctuations in the prime rate.

Revolving Debt vs Installment Debt

In addition to understanding the various terms related to interest rates, it's also helpful to understand the difference between revolving debt and installment debt. Credit cards are considered revolving debt. While there is a maximum limit that you are allowed to borrow, each time you make payments on your credit card, you can “reuse' that portion of your balance. So if you've got a credit card with a $5,000 balance, and you spend $2000, you have $3000 available. When you make a payment of $1000, your available credit now includes the $1000 that you just paid off, and you could use the card for purchases up to $4000 at that time. The available balance revolves as you pay your statements. (This is an oversimplified example that doesn't take into account the portion of a payment that is applied to interest). Revolving accounts charge the most interest.

Installment debts are loans like mortgages or vehicle loans, as well as personal loans that you may take from a bank. An installment loan is a fixed amount of money that is borrowed over a specific period of time. Your payments each month don't change (unless you happen to have an installment loan with a variable interest rate). Installment debt is easier to budget for, as your monthly payments remain constant.

Interest rates all start with the Fed rate. Basically, what the fed rate is, it is a rate that banks are offered as their borrowing rate from their local federal reserve. This fed rate is adjusted regularly by the Federal Reserve Board so that growth of an economic nature is achieved. For example, if the supple of money is reduced and the interest rates are increased, this usually means that there is oncoming inflation.

This causes the effect on mortgage rates to be not be immediate or direct from inflation or recession.

When you go to a bank in order get get a loan or mortgage to buy a new house or refinance your current house, they take that loan and sell it to various agencies. From there, the money that they get from selling the loan will go into allowing them to repeast the process and hand out more home loans.

The money that the agencies use to buy the loans come from other lenders that sell mortgage backed securities bonds. These are made of of many mortgages put together into a single bond. In the end, these bonds are considered one of the most secure investments allowing a lot of various people to invest in them. It should also be noted though, that sometimes the stock market competes with the same money that is sometimes invested in the bonds.

The competition between the stock market and the bonds depends on a number of different factors. When there are higher interest rates on the bonds, they get the upper hand and attract more investors. When the opposite happens and the stock markets are performing positively, the bulk of the investor money can go into the stock market.

Sometimes, in order to attract money and investors to the bonds that are backed by mortgages, they are given higher return on investment rates. Of course, this can in turn causes higher rates up the line to the home buyer.

Most of the time when you look at a bank's mortgage interest rate, it is an average calculated between all the different lenders across the United States. When you are looking to get a mortgage and working with your lender, the lender uses a set of criteria to determine the final rate that you will end up paying in the end. Usually, the more rick there is in the mortgage, the higher the interest rate you will end up paying.

The set of criteria that they consider are the lendee's debt income ratio, credit score rating and mortage to value ratio. This means that just because you see a specific rate posted at a bank or online, it does not mean that you will actually get that rate. Sometimes it can be more and other times it can be less. It just depends on how you fall into the criteria used. Basically, every loan is different and is done on a case by case basis.

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Both Debbie Dragon & Corey Palmer are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.

Debbie Dragon has sinced written about articles on various topics from Finances, Credit Cards and Kitchen Home Improvement. Destroy Debt has the advice and resources you need on and other financial topics.. Debbie Dragon's top article generates over 165000 views. to your Favourites.

Corey Palmer has sinced written about articles on various topics from Classics, Forex Online and Home Management. Corey Palmer is a mortgage expert and investor.. Corey Palmer's top article generates over 6600 views. to your Favourites.