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[H750]How Do Interest Rates Work

by Max Plata, Max

There are different types of interest rates depending on whether you are borrowing money or investing money.

When you are borrowing money you have to pay interest back at a set rate. These rates are determined by several factors. One of these factors is risk. If you have a bad credit rating the rates at which you pay interest on loans may be significantly higher than someone who has a pristine credit rating.

The reason for this is that the lender sees you as a risk. When you are a risk, the rates applied to your lending rise. This can make it especially difficult for someone with a bad credit rating to purchase anything major including a home or a vehicle. They may be able to afford the initial payments, but once the interest rates are added, the amount exceeds their budget.

Another factor that determines interest rates is the length of the loan. Lower interest rates are often offered if the consumer extends the period of the loan. To the consumer this may seem like a windfall. They view the smaller interest rates as a savings to them. Short term it is but since the loan is being extended to take advantage of the lower interest rates, they are actually paying out more money in interest over the length of the loan.

Interest rates do not only affect just the consumer but they have an impact on the economy as a whole as well. When interest rates climb, people are less likely to purchase goods that aren't essential to their lives. Car sales drop and home sales often plummet as well. The average consumer doesn't want to spend the extra money on the increased interest because the rise in rate just means less money in their pocket. The cost of the goods they are purchasing hasn't changed, it's the cost of purchasing those goods that has.

On the other side of the interest rates spectrum is investing. People want to invest when interest rates are high so as to yield the biggest profit. Years ago the traditional savings account was often viewed as the traditional investment tool. The bank would post their interest rates and people would save their money in the hopes that it would grow substantially over the course of a number of years.

Today you are more apt to find people investing in many diversified things; money market funds, the stock market and bonds. If you decide to invest in bonds they will have a posted interest rate. The rates on bonds might be slightly higher than other investments because with many bonds you have to lock your money in to the investment for a specific amount of time. The period can be anywhere from several months to several years.

Interest rates impact our lives everyday whether we are aware of them or not. To keep on top of both your borrowing and investment needs it's a good idea to follow interest rates.

The bank pays the payee and then charges the cardholder interest over the time the money remains borrowed. Banks suffer losses when cardholders do not pay back the borrowed money as agreed.

Typical credit cards have interest rates between 7 and 36 percent, depending upon the banks risk evaluation methods and the borrowers credit history. The cardholds credit risk is key to a card issuers profitability. Banks check national and international credit bureau reports that identify the borrowing history of the applicant.

Different Methods For Charging Interest

The Average Daily Balance is the simplest of the four methods, in the sense that it is an interest rate that produces approximately, if not exactly, equal to the expected rate. The sum is divided by the number of days covered in the cycle to give an average balance for that period.

This amount is multiplied by a constant factor to give an interest charge. The result interest is the same as if interest was charged at the close of each day, except that it only compounds (added to the principal) once per month

Next is the Adjusted Balance method where at the end of the billing cycle it is multiplied by a factor in order to give the interest charge. This can result in an actual interest rate lower or higher than the expected one, since it does not take into account the average daily balance.

What matters here is the time the money was actually lent out by the bank. The longer the period the higher the interest rate because you are using their money, which increases their risk on you.

The Previous Balance is the reverse of the Adjusted Balance. The balance at the start of the previous billing cycle is multiplied by the interest factor in order to derive the charge.

As with the Adjusted Balance method, this method can result in an interest rate higher or lower than the expected one, but the part of the balance that carries over more than two full cycles is charged as the expected rate.

Now let's take a look at the APR that is the principal means of comparing credit interest. It is compounded on a monthly basis. Most major banks use the following methodology:

Increase the figure to the highest possible value while still meeting advertising requirements, e.g., if a card is advertised at a percentage rate of 17.9, then any value up to 17.949 will still be rounded down to 17.9.

To derive the month rate, obtain the twelfth root. This will provide you will a rate which when compounded over a year will equal the APR.

At this point, it is important to round down, since the APR has already been maximized. Pushing the APR up onto a higher rate could make the card issuer liable for false advertising claims.

These are the four main methods banks, credit unions, etc; calculate their programs of charging interest for their credit cards.

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