Interest rates are at the heart of many financial decisions. Whether you’re thinking about your next mortgage loan, credit card debt or savings account — the rate you choose can have a big impact on how much you owe over time. Understanding the difference between fixed and variable interest rates, as well as market conditions and your own financial situation, can help you make a savvy decision that fits your life and goals.
In lending, an interest rate is a charge for the use of assets such as cash, consumer goods, or property. It represents the lender’s potential return if the funds had been invested elsewhere instead of being loaned out. As a result, higher interest rates generally make borrowing more expensive, while lower rates can make it less so.
There are a few different ways to calculate interest, but the most common is simple interest. This method uses a simple formula that only considers the principal amount of the loan. Compounding interest, on the other hand, takes into account the principal and accrued interest each period, resulting in a larger total sum over time.
Variable rates can fluctuate over time, depending on market conditions and a benchmark interest rate (such as the federal funds rate). If market rates rise over the course of your loan term, your interest and monthly payment will increase as well. This can make it harder to predict your long-term expenses and budget effectively.