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What is Interest Rate?

An interest rate is expressed as an annual percentage and it is used to determine if a particular lender's terms are reasonable. Lenders, for example, can charge a flat fee for a short-term loan due upon receipt of the borrower's next paycheck. Expressed as a surcharge, this interest payment may not appear excessive; perhaps a $50 interest payment on a $250 emergency loan. But calculated as an annual interest rate, the result is a relatively high 20% APR.

Some short-term loans have an annual interest rate of 150% or more if the loan is not repaid in full and the interest accrues daily or monthly. A classic example of a daily interest rate charge are credit cards. If you do not repay fully, your balance is charged on a daily rate which is the highest among all types of loans.

An interest rate can be considered 'flexible' or 'fixed'. A fixed interest rate means that the lender can only charge the same amount of interest per month throughout the life of the loan. Many borrowers prefer to find a lender who offers a fixed interest rate because the repayment terms are predictable and protected by a contract. Because the interest rate in a fixed loan cannot be adjusted, however, many lenders charge more for the loans or don't offer them in the first place. When buying a large ticket item such as a home, a fixed interest rate is almost always preferable to a flexible one.

In the case of a flexible interest rate, lenders often tie the loan's interest to the current lending rates, also known as the prime lending rate. This is the interest rate charged by governments to major banks and other lending institutions. The prime lending rate is regularly adjusted by governments, major banks or financial institution, based on economic factors such as inflation or high unemployment. Lenders can legally charge borrowers an interest rate which is a few points above the prime lending rate at the time of the initial loan. If the rate changes, the interest on the loan can also be adjusted. A flexible interest rate can be beneficial when the economy is healthy, but can be more costly if the rates are raised suddenly.

What is Compound Interest?
What is Simple Interest?
What is Interest Rate Swap?