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The Beginners Guide to Interest Rates

Our Reduction Financial guide to interest rates will help anyone understand how they work, the different types of interest rates you may encounter in financial opportunities, and the implications these rates can have on your budget.

What are Interest Rates?

Simply, an interest rate is the cost of borrowing money. When any lender offers you a loan or a credit card, it charges an interest rate to protect (and profit from) its investment. This rate is typically a percentage of what you borrow.

Types of Interest Rates

Creditors use several types of interest rates, each of which has a different purpose and affects the overall cost of borrowing differently. It pays to be aware of each type that you may encounter, to ensure you understand exactly what you are committing to pay.

Fixed Interest Rates

Fixed interest rates are the most common and simplest of the rate types. Just as it sounds, a set interest rate does not change over time. This rate offers an advantage to borrowers who prefer predictability, especially when managing a budget.

Credit card companies often offer “fixed-rate” cards, meaning that the rate remains the same no matter how much or how often you use the card. So, for example, if you keep an outstanding balance of $1,000 with a fixed rate of 15%, you will always pay $150 in interest each month.

Variable Interest Rates 

In contrast to fixed rates, variable rates are subject to change. That can make it more difficult to budget. Variable rates are usually higher than fixed rates, and can be exceptionally costly if the rate climbs as you carry a balance.

Variable interest rates on credit cards are usually tied to a benchmark rate, such as the prime rate. When that rate goes up or down, so does your interest rate on the credit card. If you have a variable rate card, it’s important to keep an eye on what the benchmark rate is doing and adjust spending on the card accordingly. If you don’t, your payment can quickly become unaffordable.

Promotional Interest Rates

Sometimes, lenders offer promotional interest rates that are lower than the standard rate (either fixed or variable) for a short period of time. These promotional rates only apply for a short time — typically a year — before reverting to their regular fixed or variable rate.

Promotional interest rates are a common reason people find themselves in a cycle of debt. It happens because people hope to take advantage of the promotional rate but then find themselves unable to pay off the card while that rate is still valid. To avoid this trap, borrowers should maintain low balances that they can easily pay off before the promotion ends. Another option is to look for cards that do not charge an annual fee and that offer a low interest rate even after the promotional period has ended.

Another common promotional rate is for balance transfers. To get your business, a lender may offer you a lower interest on your current balance if you move (or transfer) that balance to their card. It is possible to save money doing that. However, the lower rate usually only applies to the balance you transfer and not to any new purchases you make. To compensate for the low rate you’re paying on the transfer, the rate charged on new purchases may be very high. Be sure to read the fine print before accepting any balance transfer offer.

Penalty Interest Rates

If you fail to keep up with your payments or go over the credit limit on your accounts, you may be assessed a penalty interest rate. This type of rate is typically much higher than the standard fixed or variable rates (in some cases, it can approach double) and can add significantly to the cost of borrowing. In some cases, you may be able to get your standard interest rate back by making on-time payments for a specified period (such as six months). But creditors may make the penalty rate permanent, regardless of your subsequent payment history.

To avoid penalty rates, it’s important to always make payments on time and stay within the credit limit of your accounts. It’s also essential to read through the terms and conditions of a loan or account before signing up, so you know what kind of penalty fees you may face if you can’t make your payments as agreed.

What is an APR?

Applications for credit cards show an annual percentage rate or APR. This figure represents the cost of borrowing money over 12 months, including interest and other fees. By combining all the costs of borrowing, the APR is intended to make it easier for consumers to compare different credit cards or loans.

For example, if you have a credit card with an APR of 20%, this means that every $100 spent on the card (and carried over into the next billing cycle) would result in $20 of interest being charged. Keep in mind that you may not be fully able to pick and choose an APR that you like. Creditors only offer lower APRs to borrowers with good credit, so if your FICO score is fair or poor you won’t qualify for a favorable APR.

The APR is a useful metric for comparing different loan offers, but keep in mind that it doesn’t necessarily reflect the actual rate you will be charged. For example, credit cards with low APRs may have higher fees, while cards with high APRs may have lower fees. So, read the fine print on an offer before signing up to understand exactly what you are paying for.

Understanding APR is essential to avoiding costly interest charges and taking control of your finances. Doing your research and shopping for the best deals will ensure you get the lowest rate possible on any credit cards or loans you take out.

What Interest Rates Can a Credit Card Company Charge?

Currently, there are no federal regulations dictating the maximum or minimum rates they may assess. As such, credit card companies have broad discretion when setting their rates. This means that rates can vary significantly from one card to another, so it pays to shop around for the best deal.

To find a good deal, be sure to:

  • Compare the various rates, fees, and terms of credit cards
  • Look for cards with perks (no annual fee, cash back, etc.)
  • Read the fine print so you fully understand any penalty fees associated with that card

Additionally, make sure the creditor you apply to is reputable and meets the standards of the Consumer Financial Protection Bureau.

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