This simple interest calculator calculates an accrued amount that includes principal plus interest. For interest only, use the simple interest calculator.
Understanding interest rates is a key part of managing your finances. Whether you’re taking out a loan, investing money in a high-yield savings account, or just trying to avoid getting ripped off by credit card companies, you need to know how interest rates work
In this comprehensive guide, I’ll explain everything you need to know about interest rates, including:
- What is an interest rate
- The difference between simple and compound interest
- How interest rates are calculated
- Factors that determine your interest rate
- Tips for getting the best interest rate possible
I’ll also provide examples and resources to help you easily calculate interest rates in real-life situations Let’s dive in!
What Is An Interest Rate?
An interest rate is simply the cost of borrowing money, expressed as a percentage of the amount borrowed. For example, if you take out a $10,000 loan with a 10% interest rate, you’ll owe $1,000 in interest per year in addition to repaying the original $10,000.
Interest rates compensate the lender for the cost of lending the money and the risk they take by allowing you to borrow. The higher the interest rate, the more it costs you to borrow money.
Interest rates apply to all kinds of borrowing and lending situations:
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Credit cards – Credit cards typically have high interest rates of 15-25% This is how credit card companies make money.
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Mortgages – Mortgage rates are much lower, currently around 3-6% for qualified buyers.
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Auto loans – New car loans tend to have interest rates of 4-7%.
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Personal loans – Personal loan rates vary widely but average 10-12%.
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Savings accounts – Banks pay you interest to keep money in savings accounts. Rates are very low, less than 1% currently.
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Investments like bonds – Bond interest rates depend on the bond issuer and duration but are typically 1-4%.
As you can see, interest rates have a huge impact on the cost of borrowing and the return on lending. Understanding rates is essential for making informed financial decisions.
Simple vs. Compound Interest
There are two main ways interest can be calculated: simple interest and compound interest. The method impacts how much interest you ultimately pay or earn over time.
Simple Interest
With simple interest, the interest amount is calculated only on the original principal amount. Simple interest is determined using this formula:
Interest = Principal x Interest Rate x TimeFor example, if you borrow $1,000 at a 10% simple interest rate for 1 year:
Interest = $1,000 x 0.10 x 1 year = $100The interest amount stays fixed at $100 each year. Your total owed would be:
- After 1 year: $1,000 + $100 interest = $1,100
- After 2 years: $1,000 + $100 interest = $1,200
As you can see, with simple interest the interest amount stays the same each period.
Compound Interest
With compound interest, the interest you owe is calculated based on the principal PLUS any accumulated interest. This causes your interest charges to grow exponentially over time through the power of compounding.
Here is the formula for compound interest:
A = P(1 + r/n)^(nt)Where:
- A is the total amount accrued with interest
- P is the principal amount
- r is the annual interest rate in decimal form
- n is the number of compounding periods per year
- t is the total number of years
Let’s use the same $1,000 loan at 10% interest compounded annually:
- After 1 year:
- Interest = $1,000 x 0.10 = $100
- Total owed = $1,000 + $100 interest = $1,100
- After 2 years:
- Interest = $1,100 x 0.10 = $110
- Total owed = $1,100 + $110 interest = $1,210
You owe $110 the second year rather than $100 because the interest compounds on top of prior interest accrued. This extra $10 makes a big difference over time thanks to the power of compounding!
As you can see, compound interest causes debt to grow much faster than simple interest. For this reason, most loans and investments use compound interest.
How To Calculate Interest Rates
Now let’s discuss how to actually calculate interest rates. Here are the key formulas and steps:
Calculate Rate from Interest Amount
If you know the interest amount paid, you can calculate the annual interest rate using this formula:
Interest Rate (R) = Interest Amount (I) / Principal (P) / Time in Years (T) For example, say you paid $600 in interest on a $10,000 loan over 5 years. Plugging this into the formula:
R = I / P / T = $600 / $10,000 / 5 years = 0.12 or 12%Be sure to match the time period for the interest amount. If the $600 was paid over just 1 year, the rate would be 6% instead.
Calculate Interest Amount from Rate
You can also work backwards from a given rate to determine the interest amount owed using this formula:
Interest Amount (I) = Principal (P) x Interest Rate (R) x Time in Years (T)For example, a $20,000 loan at 5% interest for 3 years would accrue:
I = P x R x T = $20,000 x 0.05 x 3 years = $3,000 interestThis formula works for any time period – just use the time matching the given rate (years, months, etc).
Online Interest Calculators
For more complex loans with variable rates and compounding periods, online calculators make it easy to determine interest amounts. Sites like Bankrate and CalculatorSoup have free interest calculators for mortgages, auto loans, credit cards, and more.
I recommend plugging your loan details into an online calculator to get the most accurate interest estimate.
Factors That Determine Your Interest Rate
When you apply for a loan or open a savings account, what interest rate will you actually receive? It depends on these key factors:
1. Economic Conditions
Central banks like the Federal Reserve directly impact interest rates through monetary policy. When the economy is slow, the Fed lowers rates to encourage borrowing and spending. When inflation rises, the Fed raises rates to discourage borrowing.
For this reason, economic factors largely outside your control influence the rates available to consumers. It’s best to borrow when rates are low to get the optimal rate.
2. Your Credit Score and History
Lenders offer the best rates to borrowers least likely to default. That’s why your personal creditworthiness is so important. Key factors include:
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Credit score – In general, a FICO score above 740 is considered excellent credit and will qualify you for the lowest rates on loans and credit cards. Scores below 600 make you high risk for lenders.
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Payment history – On-time payments show responsibility while late payments indicate higher risk.
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Credit utilization – Using too much of your available credit limit signals risk as well. Ideally keep utilization below 30%.
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Credit history length – A longer history with established accounts looks better than a short, thin credit file.
Before applying for a loan, check your credit report and score so you know where you stand. Take time to improve your credit if needed to qualify for better rates.
3. Loan Specifics
The details of your particular loan also impact the rate offered:
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Loan purpose – Mortgages and auto loans are lower risk and qualify for better rates than unsecured personal loans.
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Loan term – Shorter loan terms often have lower rates since the lender’s money is tied up for less time.
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Down payment – Larger down payments reduce the lender’s risk, allowing them to offer better rates.
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Collateral – Secured loans with collateral like a house have lower rates than unsecured loans.
Consider loan specifics like these when applying to receive the most favorable interest rate.
Tips for Finding the Best Interest Rates
Here are some tips to ensure you get the lowest interest rate possible on loans and the highest rates on savings:
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Check your credit report – Make sure it’s accurate and work on improving your credit score if needed.
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Compare rates from multiple lenders. Rates vary so shop around for the best deals.
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Consider a shorter loan term – This lowers rates and helps you pay off debt faster.
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Make a larger down payment – At least 20% down signals lower risk on a mortgage or auto loan.
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Ask about discounts – Many lenders offer rate discounts for things like setting up autopay.
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Build your credit history – Open accounts like credit cards and personal loans and use them responsibly.
Simple Interest Equation (Principal + Interest)
A = P(1 + rt)
Where:
- A = Total Accrued Amount (principal + interest)
- P = Principal Amount
- I = Interest Amount
- r = Rate of Interest per year in decimal; r = R/100
- R = Rate of Interest per year as a percent; R = r * 100
- t = Time Period involved in months or years
From the base formula, A = P(1 + rt) derived from A = P + I and since I = Prt then A = P + I becomes A = P + Prt which can be rewritten as A = P(1 + rt)
Note that rate r and time t should be in the same time units such as months or years. Time conversions that are based on day count of 365 days/year have 30.4167 days/month and 91.2501 days/quarter. 360 days/year have 30 days/month and 90 days/quarter.
How to Calculate Interest Rates (The Easy Way)
What factors affect interest rates?
Four things influence interest rates: the risk of default, the length of the loan, inflation rates, and the real rate. Interest rates are generally higher for borrowers who are more likely to default.
What is the current interest rate?
The federal funds rate, which now sits at a range of 4.25% to 4.50%, is the interest rate that banks charge each other for borrowing and lending. And there’s a trickle-down effect: When it costs banks more to borrow from one another, they offset it by raising rates on their consumer loan products.
How do interest rates affect investments?
If interest rates are increased then it will tend to discourage investment because investment has a higher opportunity cost. With higher rates, it is more expensive to borrow money from a bank. Saving money in a bank gives a higher rate of return. Therefore, using savings to finance investment has an opportunity cost of lower interest payments.
How do interest rates work?
An interest rate is the percentage of principal charged by the lender for the use of its money. The principal is the amount of money loaned. Interest rates affect the cost of loans. As a result, they can speed up or slow down the economy. The Federal Reserve manages interest rates to achieve ideal economic growth.
