If you borrow money, you pay an interest rate on your loan. The interest rate is stated as a yearly percentage rate, which is the interest cost of borrowing for one year. For example, if you borrow $10,000 at 10%, your interest cost for one year is $1,000 ($10,000*.10). This interest rate is called the simple interest rate.
The periodic interest rate is calculated in a similar way. This is the interest rate that you pay for a period shorter than one year. For example, if you borrow the same $10,000 for one month, your interest cost is one-twelfth (1/12) of 10%.
To calculate your periodic interest rate, divide the annual interest rate by the number of periods. If the period is months, divide 10% by 12 to get 0.83%. The monthly interest cost of the $10,000 loan is $83.33 [($10,000)*(.10)*(1/12)]. If you are saving instead of borrowing, the same interest rate calculations apply. Instead of paying interest, however, you earn interest income.
The compounded interest rate assumes you "earn interest on interest." As a result of compounding, you pay (as a borrower) an interest rate that is higher than the simple interest rate. Alternatively, you earn a higher rate (as an investor) than the simple interest rate. The following table shows monthly compounded interest on a $10,000 loan at a 10% annual interest rate. (Compounded monthly, the periodic interest rate is 0.83%):
(You can verify these figures by looking at the Results in the calculator, which was introduced above.)
As the table shows, compounded interest grows faster than the simple interest rate for all periods. However, the compounded interest rate remains at 10.47%. This is because you are compounding on a monthly basis. If you increase the compounding frequency to a daily basis (assuming a year is 365 days), your compounded interest rate would increase to 10.52%.
The compounded interest rate is the real rate of interest you earn (as an investor) or pay (as a borrower). It is also called the effective interest rate. If you are a borrower, the effective interest rate is also called the annual percentage rate (APR). If you are an investor, the effective interest rate is also called the annual percentage yield (APY).
The APR includes any closing costs you pay on a loan. For example, if you borrow $10,000 and pay $500 in closing costs, you effectively borrow $9,500. (This assumes you pay your closing costs at closing instead of financing them by adding them to the loan amount.) Closing costs increase your loan interest rate. The following table shows the APR for a range of closing costs. Loan terms are a one-year loan at 10% simple interest:
As the table shows, APR rises sharply as closing costs increase. The rate more than doubles to 22.2% when closing costs are $1,000. This should make some sense: Since $1,000 is 10% of $10,000, and you are paying an interest rate of 10%, the two rates together added together equal about 20%.
You should always ask a lender to show you the APR. After all, it is your true cost of borrowing. In fact, consumer protection laws require the lender to show you the APR. If the lender is unwilling, you should apply elsewhere for a loan.
Deciding when to borrow, invest, or refinance a loan depends on the level of interest rates. Over years, interest rates rise and fall in the pattern of a cycle that is consistent with the rise and fall in the overall economy. When the economy is expanding, demand for loans is high. High loan demand leads to higher interest rates. When the economy slows down or contracts, the demand for loans is low.
A slowdown in the economy usually leads to lower interest rates, encouraging borrowers to refinance existing debt. Presently, in late 2003, mortgage rates are at 40-year lows as a result of the substantial slowdown in the economy.
The Federal Reserve plays a central role in determining future interest rates. The Federal Reserve, or Fed, is the U.S. central bank. It is responsible for setting monetary policy in the U.S.
The Fed's main policy-making committee, the Federal Open Market Committee (FOMC), meets about every six weeks to evaluate key indicators of the economy's health. If it anticipates a slowdown, it may cut the fed funds or discount rate, or both. If the Fed anticipates inflation or too much growth, it may raise rates. Through December 2003, the Fed has cut the fed funds rate 14 times since January 2001 to 1.00% in order to stimulate the economy.
Keeping an eye on interest rates helps you to decide when to borrow and when to invest. When interest rates are heading lower, it may be a good time to borrow. (However, rates can continue to decline, making borrowing even cheaper.) On the other hand, if rates are rising, you can earn a higher rate of return by investing in money market accounts, money market mutual funds, and CDs. All of these savings instruments earn a higher rate of return when interest rates are rising.
Savvy investors and borrowers aim to keep the effective interest rate on their borrowings lower than the effective interest rate earned on their investments. Given a chance to repay debt, a savvy borrower chooses to pay down or pay off the high-interest debt first.
Finally, you can take advantage of fixed-rate loans and investments to hedge against adverse movement in interest rates. For example, if you think rates may rise, a fixed-rate loan locks in your interest rate. On the other hand, if you think rates will fall, a variable-rate loan such as an adjustable-rate mortgage (ARM) will lower your loan payments as interest rates fall. For all of these reasons, managing interest rates will help you to improve your personal cash flow.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.