What are interest rates and why do lenders charge them?
When you need to borrow money you have several options – for car loans, you might visit your local car dealership; for mortgages, you might visit a bank or mortgage lender; for daily spending and internet purchases, you might get a credit card.
None of these organizations are charitable organizations. They are in business to earn a profit and the interest they charge is the price you pay for borrowing their money. Interest rates on loans have been around for thousands of years.
Although it’s the lender that charges you interest to borrow money from them, many people do not realize that they can sometimes influence the amount of interest they pay and with wise credit management, you can stand to save thousands of dollars in interest charges.
That’s because lenders often adjust interest rates based on risk. The riskier it seems to loan the money, the higher the interest rate charged, which is why secured loans often have lower interest than unsecured loans and credit cards.
Lenders use credit scores to help them assess risk. So you could potentially pay a lower interest rate if you have a higher credit score. Conversely, you could pay higher interest rates if you have a lower credit score.
(Of course there are some exceptions to this rule. Credit card companies, for example, may have pre-established interest rates on their credit cards, but it’s useful to know that all interest rates from any lender is not an arbitrary number of a carefully determined one).
So, how can you save money on interest rates?
- The first thing you can do is work on your credit so that when you apply for a loan or a credit card, the lender sees a nice high credit score and perceives you to be a lower lending risk. That’s the first and most important step you can take.
- Second, you will often pay much, much less in interest charges if you pay your credit account down as quickly as possible. On most credit cards, for example, you won’t be charged any interest when you pay off your balance each month, but you will pay interest if you carry a balance. So the more you can pay down the balance, and the faster you can pay off your balance, the less in interest you will pay. And the same holds true for any loan – the faster you pay off the loan, the less you’ll pay in interest. (Be aware, though, that some loans, especially larger ones, will charge you a fee if you pay off your loan too quickly).
Interest rates are the price we pay to borrow money and in the big scheme of things, they are a welcome price because we need to have access to money. But if you are aware of how interest rates are derived, you can manage your own credit carefully to ensure that you don’t pay too much in interest charges.