What Is An Annual Interest Rate?
Maybe you want to invest in a house, buy a car, or apply for a credit card. No matter the case, unless you’re well-versed in finance, you’ll probably run into a few unfamiliar terms.
One of the first questions new borrowers tend to have is, what is an annual interest rate? They might go on to wonder how it differs from an annual percentage rate or APR. And, while we’re on the subject, is that the same as an APY?
Before you get lost in a maze of financial jargon, take a deep breath. We’re here to help explain what an annual interest rate is. While we’re at it, we’ll cover those other similar terms too.
So by the time you’re through reading this article, you’ll know exactly what to look for in a financial product.
Annual Interest Rates Explained
- Base rate
- Standard rate
- Advertised rate
- Prime interest rate
Why the Annual Interest Rate Is Important
The annual interest rate doesn’t include any fees, nor does it account for compound interest in the case of a savings account or investment.
So, it can differ greatly from the “true cost” of a loan or the actual amount your savings will grow over time. For this reason, some believe the annual interest rate isn’t important.
However, the annual interest rate is still crucial to understand when comparing loan options because it’s the figure that all other rates are based on. It’s also vital to know if you want to calculate interest on the loan yourself.
How the Annual Interest Rate Is Determined
Financial institutions set annual interest rates individually but typically reflect the Federal Reserve’s federal funds rate.
The federal funds rate is the rate that banks use for other banks when they lend reserve balances to them. By law, banks must maintain a reserve equal to a percentage of their deposits at a Federal Reserves bank.
That way, they’re sure to be able to cover withdrawals and any other obligations. If they have more in their reserve than required, they can loan to other banks at the federal funds rate. As the federal funds rate increases, individual banks will increase their base interest rates to reflect it.
Various economic factors influence the Fed’s decision to lower or increase the federal funds rate. Their dual mandate, as set by congress, is to maximize employment while keeping prices stable.
So, when there’s too much inflation, the Fed typically increases the interest rate, and when unemployment is too high, they do the opposite.
Of course, there are exceptions to these guidelines, and the Federal Reserve may make a different decision depending on numerous economic factors.
Regardless of why they raise or lower interest rates, financial institutions follow suit, increasing or decreasing the base interest rate on their loans and financial products.
So, whether you’re opening a credit card or taking out a home mortgage, an increase or decrease in the federal funds rate will affect you.
Understanding The Annual Interest Rate: An Example
To illustrate how the annual interest rate works and how it affects your monthly payment on your car, home, or credit card, let’s look at a basic example.
Let’s say you’re considering a $400,000 home mortgage. The base interest rate set by the bank is 8%. That means you’ll pay $32,000 yearly interest or $2670 monthly. At a lower interest rate of 6%, your monthly payment will be significantly lower.
You’ll pay $24,000 in yearly interest and $2000 in monthly payments at the lower interest rate. That means, at only two percentage points lower, you’ll save $8,000 per year.
Of course, the base interest rate isn’t the only thing to pay attention to when borrowing money. There are other fees to be aware of, which means you need to understand other financial terms, like the annual percentage rate (APR).
Annual Interest Rate vs. Annual Percentage Rate (APR)
- Brokerage fees
- Processing fees
- Underwriting fees
- Origination fees
- Title insurance
- Appraisal costs
- Mortgage points
- All other 3rd party closing costs
Why APR Is Important
How To Find Your APR
Whether you’re dealing with credit cards, bank loans, car loans, or home loans, you’ll need to know the annual percentage rate.
The federal government, via the Truth in Lending Act (TILA), requires banks, credit card companies, and other consumer credit lenders to disclose certain information, including the annual percentage rate.
You’ll find the APR listed on your loan or credit card documents. You may also find it listed on your monthly statement.
Types of Annual Percentage Rate (APR)
APR comes in a few different forms, depending on the type of credit you’re taking out.
Credit card companies can charge several different types of APR, meaning the APR they charge on purchases can be different from the APR they charge on balance transfers or cash advances. On top of that, credit card issuers may charge penalty APRs on late payments or to customers who break the terms of the cardholder agreement.
Bank loans, including auto loans and home loans, can offer variable or fixed APR. With variable APR, the interest rate can change at any time. With fixed APR, the interest rate does not change throughout the life of the loan.
How APR Works with an Example
APR depends on the base interest rate plus fees. It will also vary based on your credit history. Those with good credit scores will get lower APRs, and those with poor credit scores will receive far higher APRs.
For example, let’s say you’re comparing 30-year fixed-rate mortgages from two banks. You need a $250,000 mortgage, and both banks are offering a 3% interest rate. However, their fees differ as follows:
Bank A
- origination fee: $2,500
- discount points: $2,500
- closing costs: $1,100
Bank B
- origination fee: $1,250
- discount points: $2,500
- closing costs: $1,150
To compare the two loans directly, you need to look at the APR. There are several online tools for calculating APR, which makes this process easy. Typically, you’ll simply need to fill in the loan terms and stated fees. Or, you can find the APR stated in the loan documents.
When you do this, you’ll find that bank A’s APR is 3.12%, and bank B’s APR is 3.118%. So, even though both banks offer the same advertised interest rate, bank B offers a slightly more affordable loan.
Interest Rate vs. APR vs. APY
The annual percentage yield comes into play with a savings account or other investment in which there’s interest paid to you. It will tell you how much interest your savings account or investment will earn, taking compounding interest into account.
In the same way, you would use an APR to compare bank loans or credit card offers, you might use the APY to compare investment products. Standard or annual interest rates on savings accounts and investments don’t include compounding interest. So, the APY gives a better picture of how much money your account will generate over time.
Frequently Asked Questions
How do I know my annual interest rate?
How can I lower my interest rate?
You can lower your interest rate by raising your credit score and by maintaining a clean payment history. Don't miss payments on credit cards or loans you already have outstanding. That will help you lower your interest rate on any future loans.
You can also make a larger down payment, shop lenders for a better rate, or consider purchasing mortgage points in the case of a home loan.
What is the annual interest rate monthly?
What is good annual interest?
Annual interest rates vary significantly based on several factors, so a good rate is subjective. In terms of credit cards, anything below 14% is considered good. For auto loans, anything below 5% is good, and for mortgages, 6% is considered good at the time of this writing.
However, as the Federal Reserve adjusts the federal funds rate, what's considered good could change significantly.
How do you avoid annual interest rates?
While you can't avoid interest on loans, you may be able to avoid paying interest on your credit card purchases.
Most credit card companies offer a grace period lasting 21 days from the start of your monthly statement. During that period, your purchases will not acquire interest. So, if you pay off your card within the grace period, you will avoid paying interest.
Final Thoughts
Annual interest rates are important to understand, but they’re only part of the equation when considering a loan, credit card, or savings account.
To compare financial products, you need to know other things like the annual percentage rate or annual percentage yield. Once you understand all of that, you’re well on your way to making a wise financial decision.
