Unless you pay cash for everything, you’re impacted by interest – either as a lender or as a borrower. Understanding the different types of interest can give you a clearer picture of how your money accumulates and what things really cost when financing is factored in.
Interest rates for lenders. Most people don’t think of themselves as lenders, but if you have a savings account or own government or business bonds, you are, in effect, lending money to those institutions and earning interest on the loan. This interest income is often taxable, so shop around for the highest rates to maximize your earnings and help offset inflation.
Savings and interest-bearing checking accounts typically offer low rates – often 1 percent or less. Some even charge fees for not maintaining a certain account balance. You’ll probably do better putting your money into a money-market deposit account or a certificate of deposit. Check www.bankrate.com to compare rates at local and national institutions.
Interest rates for borrowers. Interest has even more impact on you as a borrower, particularly for large credit purchases. Think about it: You could be paying off your home for 30 years or more, so reducing the interest rate by a few points could save tens or hundreds of thousands of dollars over the life of the loan.
Banks charge several different interest rates, depending on the type of loan. Secured loans (those "secured" by property such as a house or car) are often tied to the discount rate the Federal Reserve Bank (the Fed) charges its member banks for loans.
The Fed typically adjusts the discount rate upward when the economy shows signs of becoming overheated (inflation), or downward when the economy’s sluggish (thereby making loans more affordable). Banks pass these increases and decreases on to their customers through higher or lower interest rates, respectively. When rates are particularly low, people often refinance their mortgages to take advantage.
Interest rates for home equity loans and lines and credit cards are often tied (or indexed) to the bank's prime rate, which is the rate it charges its best, or "prime," customers. Because the prime rate has more than doubled since 2004, your interest rates for these types of loans may have climbed recently.
Fixed vs. adjustable. Home mortgages feature interest rates that are either fixed for the life of the loan, or adjustable at predetermined intervals for part or all of the loan period. When rate indexes (like the 10-year Treasury note) are relatively high, some people opt for an adjustable rate mortgage (ARM), which typically has a lower initial rate and is therefore more affordable at the outset. Be careful, though, because when rates climb, monthly ARM payments can rise sharply, often by hundreds of dollars a month.
Practical Money Skills for Life, a free personal finance management site sponsored by Visa Inc., has more information about how interest rates work and other credit issues, at www.practicalmoneyskills.com/learn/credit.
It pays to think of yourself as both a lender and a borrower. Remember, if you’re earning 2 percent on savings but shelling out 18 percent on loan balances, you’re actually losing 16 percent – plus paying taxes on the earnings.
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