How Interest Rates Work
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Interest Rate Primer
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If you borrow money to buy something rather than save the amount necessary to make the purchase, there will be interest charged that is based on several factors. First, the lender will judge how much risk he is taking in making the loan to you and will base the interest on that, because lenders realize that some borrowers will not be able to pay off their loans when they are due. Therefore, it is always smart to maintain your credit score to keep interest on loans low. In addition, the lender may have to pay interest for the funds he lends you, so he will base your interest rate on that factor, plus an amount for profit. Finally, general market conditions will dictate how much interest you will pay. So, if you borrow $1,000 for a year at 6 percent, you will pay a total of $1,060 when the loan comes due.
Interest Rates Cut Both Ways
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As said above, lenders often have to borrow money that it lends or uses for other purposes. So a bank will make it attractive for you to keep your money there in savings or a checking account by paying you interest on those funds. Also, local, state and federal governments pay interest on the bonds and other instruments that you may purchase from them. But since banks and governments stand little chance of defaulting on the loans they have made to you, they pay a smaller rate of interest than you do when you borrow money.
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Different Loan Types Dictate Interest Rates
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For example, an unsecured loan will always carry a higher interest rate than a secured loan because of the added risk of repayment. For instance, if you borrow $10,000 from a bank and secure the loan with an equal amount of stocks or bonds, you will pay a lot less interest than if you borrowed the money without collateral. In addition, the longer the time that the loan will remain outstanding, the higher the interest generally will be. For example, when you buy Treasury Bonds from the federal government that mature in 30 years, you will usually receive a higher interest rate than if you had borrowed the same amount for one or two years.
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