Why Is Interest Rate Important?

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Interest rate is either what you receive for investing money or what you pay for borrowing other people's money. The amount of interest or the interest rate makes a difference in how soon you pay off your loan, the amount of payment you make to the company or the length of time you pay. The amount of interest you receive makes a difference in the rate of growth for your money.

Function

  • Interest is a payment for the use of money. If you keep your funds in a bank, they use it to loan out money to others. If you purchase a bond, the company actually is receiving a loan from you. When you purchase an item on credit, the interest is the money you pay for using the funds of others.

Types

  • You can receive interest that compounds or simple interest. Compound interest and the number of times per year it compounds is the best to receive if you're investing money. If you had $100 in the bank and they offered a simple interest rate of 12 percent, at the end of the year, you'd only have $112. If you had a compound rate of 12 percent monthly, at the end of the year you'd have $112.68. While the additional 68 cents doesn't sound like much, when you imagine $100,000 with daily compounding compared to simple interest, the difference begins to be significant.

Time Frame

  • Higher interest rates require the same payment for a longer period to pay off a loan or credit card. If you have a 24 percent interest rate and a pay $50 a month on a $500 credit-card balance, it will take you 12 months to pay off your debt with $63.52 toward interest. If you pay the same amount with an 8 percent interest rate, it will only take you 11 months to pay off the balance, and you'll pay only $19.21 in interest.

Size

  • The size of your payment varies by the interest rate you pay. If you have a home mortgage for $100,000 and intend to pay it off in 30 years, at a 6 percent rate, you'll pay $599.55 a month plus any escrow. If the interest rate increases to 8 percent, your payment increases to $733.76 a month plus any escrow. You pay the additional $134.21 every month for the life of the loan, all 360 payments. That's more than $48,000 that could be in your pocket.

Considerations

  • In order to receive a higher interest rate for your investments, you have the option of investing in riskier items, using longer-term investments, and locking up your money or getting a rate for a jumbo investment. Most people either look for a higher return by using riskier investments or longer-term investments that pay more. Simply by keeping your savings lower and using a year CD, you often can increase your interest rate. However, some banks offer interest on special checking accounts with minimum balances or high interest savings accounts for people with high savings balances. These are also worth comparing.

Prevention/Solution

  • If you're paying a higher interest rate, often it's because of high amounts of unsecured credit or a bad credit rating. Sometimes, however, credit-card companies arbitrarily raise rates. When this happens, you can save money by shopping for a lower rate and transferring balances or calling your credit-card company to see if they can offer a lower rate. Saving just 1 percent often makes a huge difference.

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