Borrowing money usually involves paying back more than you originally borrowed. Alternatively, saving money usually results in accumulating more than you originally deposit. The additional amount, or interest, is a percentage of the original loan or deposit. Lenders determine the percentage, or interest rate, to charge by looking at factors such as the type of loan and your credit history. Savings accounts usually display an interest percentage. Most financial institutions disclose interest rates using the term "Annual Interest Rate" or "Annual Percentage Rate."
How It Works
Lenders determine the amount of interest by using the annual interest rate and a process called compounding. Compounding involves applying a formula that multiplies the original amount of the loan or deposit by the annual interest rate and then adding the result to the balance of the loan or deposit. This process repeats itself using the new balance and a compounding schedule. Compounding can be yearly, quarterly, monthly or even daily, depending on the account and financial institution. The more often compounding occurs, the more interest you pay on a loan or accumulate in a savings account.
Types
Two types of annual interest rates include a stated annual interest rate and an effective annual interest rate. The stated annual interest rate is an interest rate that does not take the frequency of compounding into account. For example, if the stated annual interest rate on a $1,000 loan is 12 percent, the annual interest is $120. Contrast this with the effective annual interest rate that does take the frequency of compounding into account. If the same $1,000 loan compounds monthly, the interest charge will be $126.83, making the effective annual interest rate 12.68 percent.
Characteristics
Annual interest rates are fixed or flexible. A fixed annual interest rate does not change over the course of the loan or the time funds are in the savings account. If the annual interest rate is 12 percent now, it will be 12 percent five years from now. A flexible interest rate, however, changes over time. You start out with an initial annual interest rate that will change at a specified time. The new annual interest rate will depend on market factors, such as the prime lending rate. An example of a loan that uses a flexible annual interest rate is an adjustable rate mortgage.
Considerations
It is important to consider the annual interest rate when you apply for any type of credit or loan and know how often compounding occurs. For example, credit card companies state an Annual Percentage Rate, or APR, that can result in considerable interest charges depending on how they compound interest. In addition, pay attention to expiration dates for advertised introductory annual interest rates on new accounts, as after this time standard interest rates will apply.
Warning
Instead of disclosing an annual interest rate, some lenders charge a flat fee and call it a finance charge or surcharge. They add the surcharge to the amount of the loan and you pay this fee whether you pay the loan off early or according to repayment terms. Annual interest rates for these loans can run as high as 400 percent for a two-week loan, according to the Consumer Federation of America's consumer information website. Payday and car title loans, tax return advances and bank direct deposit advance programs are examples where you may see surcharge fees.
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