Interest rates! What are they?
I like to explain interest rates as the cost or price of money in order to borrow it today. This directly relates to a concept called the time-value of money (TVM). TVM is the idea that a sum of money is worth more today than anytime in the future. This is a core principle in economics and finance, and helps explain why interest rates exist.
Conceptually, it’s important for you, the reader, to understand that when money is borrowed a fee is added. Think of this fee as a service fee, or a fee of convenience. The borrower is accessing money they don’t have today. Now, if the borrower is unable to pay the money back in full at the due date, the lender will need to borrow to pay that fee until the loan is paid back in full. A common term for the money being borrowed is principal.
Now that we have an understanding of why interest rates exist and what they are, let’s talk about how they may present themselves.
Interest rates can be found in any type of loan. You will see them associated with mortgages, student loans, personal loans, credit cards, home equity loans, home equity lines of credit (HELOC), auto-loans, etc.
You will even see an interest rate associated with high yield savings accounts, certificates of deposits (CDs), bonds, etc. In the case of these accounts, the bank is borrowing money from the depositor. The important distinction to make is whether you will be the lender or the borrower.
Let’s now focus on two common variations of interest rates: fixed interest rates and variable interest rates.
Fixed Interest Rates are the easiest to comprehend because they remain constant; they do not fluctuate or change. You can find mortgages, student loans, personal loans, and car loans with fixed interest rates. Calculating interest payments takes a little math, but there are plenty of calculators online to help. The value of a fixed interest rate is that you can anticipate the cost of borrowing money today with certainty. You know that your payments will not change and this can be very useful when you need to stick to a budget.
Variable Interest Rates are more complicated than fixed interest rates. They come with uncertainty because the interest rate can rise and fall at different periods of time in the future. This is specifically because they’re tied to a benchmark interest rate (index) linked to the Federal Reserve or London Interbank Offer Rate (LIBOR). In other words, economic factors outside of your control will determine whether your variable interest rate increases or decreases. Because the interest rate factors into the monthly payment, an interest rate increase could cause the monthly payments on a variable interest loan to double or even triple.
So why would anyone accept a variable rate? One reason is that variable interest loans typically offer lower rates than comparable fixed rate loans. If the borrower plans correctly, they may be able to pay the loan back in full before the interest rate increases. For example, a common loan with a variable interest rate is the adjustable-rate mortgage (ARM). If a new homeowner buys a home with a 5/1 ARM loan (5/1 means they have 5 years of a fixed interest rate, and then the rate will adjust once each year after that) and sells before the 6th year, they may have been able to secure a low-interest rate for the first 5 years and sold the property at a profit before their interest rate could increase.
Another very common credit tool that many of us have is a credit card. Credit cards have variable interest rates and they are usually very high! This is why you always want to pay your credit cards in full.
In short, remember that it’s about the time value of money (TVM). It’s a question of using money today to achieve a goal versus how long and how much it will cost you to pay it back. This is how you approach understanding the differences between variable and fixed interest rates.