What is an Interest Rate? How Your Credit Rating Can Determine the Cost of Financing

When you hear the term “interest rate,” does your brain start to spin with numbers and jargon? Borrowing money from a lender is hardly ever free. You have to pay back that money with interest. That’s where it can get tricky because most people want to pay the least amount of interest as possible. 

Interest is the cost of borrowing money and it’s shown as a percentage of your balance. 

The first time I learned about interest firsthand was when I took out my student loans. So many people told me to prioritize federal student loans, and I see why — they had a much lower interest rate than private student loans. 

There are different types of interest rates, and the rate you receive can vary based on different factors. I’ll break it down so you can feel like a pro when dealing with financing costs.

There are a few types of interest rates you’ll come across, and each one can have a big impact on your monthly payment.

Fixed Interest Rates

Fixed interest rates are your straightforward, no-surprises kind of interest rate. With fixed interest rates, you’ll know exactly what you’re paying every month because the rate never changes throughout the term of your loan. 

It’s like locking in the price of gas for life (wouldn’t that be nice?). But with a fixed interest rate, you know exactly what to expect and budgeting becomes a breeze.

Variable Interest Rates

Variable rates are the wild cards of the bunch. These fluctuate based on market conditions or a benchmark rate, meaning your payments could go up or down over time. On one end, if interest rates are trending lower, you could have a reduced monthly payment, but there’s also the risk of paying more if and when rates increase. 

Because variable interest rates fluctuate, you could benefit from a lower rate or find yourself paying significantly more if rates rise.

Variable interest rates are common with a line of credit — including a HELOC — where you can borrow money as needed at various times before paying it back on a set schedule.

Some lenders, especially with mortgages, have an interest rate cap, so you’ll never get a rate that higher than a certain amount. In the home loan world, this is commonly referred to as an adjustable-rate mortgage or ARM.

APR (Annual Percentage Rate)

Think of APR as the big-picture version of interest rates. It includes not only the interest you’ll pay on your loan or credit card but also any fees or extra costs, giving you a clearer idea of how much that financing will actually cost you.

APR provides that as a percentage, which is what you will pay annually on the debt you carry. For credit cards, the amount you pay may fluctuate as you make purchases and payments. But with products such as auto loans, your APR will determine what your payments will be over the life of the loan.

Lenders don’t just throw out random numbers when offering you a rate — they carefully consider several factors. If you ever found yourself wondering, “Why did I get this specific interest rate?” here are some factors that go into determining your interest rate.

Economic Factors

This is the stuff that’s a bit out of your control. When the economy is booming, interest rates tend to be lower because lenders have more money to lend. When things slow down, rates may rise to make up for the lack of borrowing. 

Interest rates can fluctuate based on things like inflation, economic growth, and central bank policies. So, the next time you see headlines about the Federal Reserve raising or lowering rates, understand that those changes could eventually trickle down to you.

Your Creditworthiness

Here’s where you come in. Lenders assess your credit score and financial history to determine how risky it is to lend you money. If you’ve got a great credit score, you’ll likely get a lower interest rate. But if your credit score isn’t looking too good, you might end up with a higher rate.

When I was younger and didn’t have much of a credit history, my car loan had a higher interest rate. This significantly impacted my monthly car payment, and I focused on trying to pay down my car loan sooner. A few months ago, I had to get another car but had a much better credit score, and this was crucial in helping me lock in a lower interest rate for my auto loan. 

Type and Term of Financing

Not all loans or credit products are created equal. Lenders will consider whether the loan is secured (like a mortgage) or unsecured (like a personal loan or credit card), as well as the repayment term. 

Longer-term loans often have lower monthly payments but may come with higher interest over time.

Long-term loans, such as a 30-year mortgage, may have manageable monthly payments, but you’ll pay a lot more interest over the life of the loan.

This may happen with a 15-year term for a mortgage vs. a 30-year term, for example. A 30-year mortgage is going to have a lower monthly payment, but you’ll pay more interest over a longer span of time. More of your monthly payment will also go toward interest during the first few years. 

On the flip side, some people prefer a lower monthly payment that’s easier to budget for, so this is just a tradeoff they are willing to make. Ultimately, it’s up to your preferences and financial goals.

Interest rates aren’t just numbers that sit on a page — they have real-world consequences for your budget. Let’s look at how they affect what you pay each month and how much you’ll owe in the long run.

Monthly Payments

Here’s the thing about higher interest rates: they make your monthly payments go up. Imagine you take out a $10,000 loan with a 5% interest rate and a five-year repayment term. Your monthly payment could be around $188.

Now, let’s say your interest rate jumps to 12% if you have average or poor credit. Your new monthly payment would be around $222, and you’ll pay $2,023.93 more in interest over the life of your loan. 

Total Cost of Borrowing

This is where things get serious. The interest rate doesn’t just affect your monthly payments; it also determines how much you’ll end up paying overall. This is thanks to something called compounding interest, which means you pay interest on both the principal amount and any accumulated interest.

In other words, your monthly interest is calculated based on the total amount you owe, rather than the amount you borrowed.  

The longer it takes to pay off a loan or credit card balance, the more you end up paying. So, while you might have borrowed $10,000, by the end of the loan term, you could end up paying back $12,000 or more — depending on that interest rate. It’s like buying clothes on sale but ending up paying full price after all the interest. 

Thankfully, you have some control when it comes to scoring the best interest rates. Here are a few tips to help you get those sweet, low rates.

Improve Your Credit Score

Your credit score is a huge factor in the interest rate you’ll be offered. The better your score, the more likely you are to get a lower rate. If your score could use a boost, try paying off some debt, making on-time payments, and keeping your credit utilization low.

I once boosted my score by 100 points over the span of a few months by paying off a lingering credit card balance and getting some of my other debts under control. Doing this helped me get a better interest rate on my next loan.

Each situation is unique, and while I can’t guarantee anyone else results, I can say from my own experience that practicing responsible financial habits can pay off over time when you’re trying to improve your credit score. 

Shop Around for Rates

Don’t settle for the first offer you get. Compare rates from different lenders or credit card issuers. A little bit of shopping around can make a big difference in the long run.

Even a small difference in rates can save you hundreds or thousands over the life of a loan. Some credit reporting agencies even have policies that don’t penalize consumers for rate-shopping, lumping similar credit inquiries during a certain time period together.

This effectively means multiple inquiries may be counted as one hard pull. Shopping around for rates is also easier these days thanks to loan comparison websites. Just be sure to check that the site you’re using is legitimate and credible. 

Consider a Shorter Loan Term

Shorter-term loans usually come with lower interest rates but may have higher monthly payments.

So, if you can afford it, going for a shorter-term loan can save you a lot of money in the long run.

Even though the payments are a bit higher, the loan is cheaper because the interest is not compounding over a significantly longer time period.

And those slightly higher payments also mean you’ll be free of the debt faster, which can free your money up for other financial needs — or wants.

Interest rates can seem tricky, but once you understand how they work and how lenders determine yours, you’re in a much better position to navigate loans and credit cards. Keep in mind that for bigger loan amounts (like a home or car loan), even the smallest change in your interest rate can cost or save you thousands of dollars over the life of the loan. 

Your newfound knowledge of interest rates can save you money since you’ll know exactly what to do to improve your chances of getting a lower rate. So be mindful of your credit score, shop around for loan and credit card offers, and be sure to choose the credit products that are going to be the best fit for your financial needs and goals.