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Breaking down different types of interest and why they matter

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Are you thinking about buying a home, applying for an auto loan, or a credit card? When you agree to borrow money from a lender, it comes with terms and conditions as well as a defined interest rate.

Generally speaking, Interest is the cost of using somebody else’s money. But different types of interest apply to different asset classes and lending agreements. By understanding the types of interest that apply to you, you can manage your budget and look for the best deal from lenders.

The types of interest rates

Understanding the various interest rates can help you calculate loan costs and ensure that you are getting the best deal. Below are the different types you may encounter:

Nominal interest rate – Refers to the interest rate before taking inflation into account. Nominal can describe the advertised interest rate on a loan

Prime rate – The interest rate benchmark that banks use when making personal loans. The bank's best clients with favorable credit scores and long-standing customer histories can receive the prime rate when applying for loans. 

Consumers with scores in the 680 to 739 score range, for example, are considered prime borrowers and typically offered very good terms although their interest rates may be slightly higher than what super-prime borrowers pay . 

Federal funds rate - The rate at which banks lend each other money in the overnight market. The federal funds rate also influences the prime rate as well. The prime rate acts as a benchmark for the consumer lending market while the fed funds rate sets the benchmark for institutional lenders

Annual percentage rate (APR) – Credit card companies, auto loan providers, and personal loan specialists use this model to calculate your interest rate. The APR is the amount of total interest you owe on outstanding loans expressed in an annual format. Banks typically calculate APR by adding the margin charged to the consumer on top of the prime rate.

Discount rate – This refers to the interest rate the Federal Reserve uses to lend to large financial institutions over the short-term, such as overnight. Banks may require the discount rate to boost liquidity or cover shortages in daily funding.

The two types of interest rates that apply primarily to consumers are APR and the prime rate. The discount rate and federal funds rate, in contrast, apply to institutions. 

Did you know?

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What are the types of interest models that apply to you? 

Simple interest

Simple interest is the rate that banks use to calculate the interest rate that they charge you. It is calculated by multiplying the principal amount by the interest rate and the term. 

For example, let's say you deposit $1,000 into a money market account paying 1.5% interest for 3 years. In this case, the calculation would be $1000 × 0.015 × 3 = $45

Variable interest

Interest rates fluctuate over time due to changes in the economy. The United States Federal Reserve responds to changes in the economic climate by adjusting the federal funds rate. As a result, these changes also affect the prime rate charged to consumers.

Borrowers may benefit from taking a loan with a variable interest rate in the current economy as the Federal Reserve announced that it would be cutting interest rates from 2019 to the end of 2020.

If you were to take an adjustable-rate loan, you may benefit from the current monetary policy. As the Fed cuts rates, benefits spill over into the consumer market and the interest costs on your loan could decline. However, if you sign a loan agreement with variable interest terms, it can go against you as well. If the Federal Reserve decides to raise interest rates as it did from 2014 to 2018, then the interest costs on your loan may increase.

Fixed interest

When you apply for a fixed interest rate on your business or car loan, the lender may set the interest rate for the entire loan term. Fixed rates are the most popular choice for consumers since it's easy to understand and calculate the costs involved with the loan.

As an example, consider a $1,000 personal loan from a lender to a borrower. With a fixed interest rate of 5%, the cost of the loan is $50. When you pay back the lender, you pay back the $1,000, as well as the $50 in interest charges.

Compound interest

Banks often refer to compound interest when calculating bank rates. The banks calculate compound rates using the principal and interest and work out the loan interest on an annual basis.

Lenders will also include the interest amount to your loan balance. They use that amount to calculate the following year's interest on the loan, or what some certified public accountants (CPAs) call "interest on the interest" of credit account or loan.

Why your credit score matters

When banks assess you for a loan, they rely on your credit history to build your risk profile, which determines the interest rate that the lender will offer you on the credit account. The better your credit score, the lower your interest rate and the lower your loan costs, allowing you save more. 

Your credit score is critical to obtaining the best interest rate possible. However, many U.S. citizens and newcomers to the country don't have a credit history. If you try to apply for home loans or any form of credit with no credit history or a poor credit score, the chances of receiving approval may drop significantly.

Even if the lender chooses to take a chance on you, they may end up charging you a high APR. Keeping your credit score in good standing usually helps you receive the best deal from a lender when applying for credit.

What happens if you have no credit history?

Traditionally, most newcomers to the U.S. have had to start from scratch when building their credit history. Their credit history stops at the border, which can be particularly frustrating for those who have built a credit history abroad. If you’re from countries like Mexico, India, or Canada and have a record of on-time payments at home, you can now use Nova Credit to translate your international credit history into an equivalent report for U.S. lenders through our partner organizations. Companies like American Express and MPower partner with Nova Credit to incorporate the choice to share your international credit history into their application process. 

Once you establish a U.S. credit account using the credit you’ve earned elsewhere, you can start building a local credit history. Here are some cards we suggest for U.S. newcomers. 

The takeaway

Credit history is a key part of the U.S. financial system, but it can take a while to build a healthy credit score. Establishing good financial habits at a young age is a key step towards healthy financial habits. 

Use your international credit history to start your U.S credit history

New to the U.S.? Check if you can use your country's credit history in the U.S. to apply for credit cards and start your U.S credit history using Nova Credit. No SSN is needed to start your U.S credit history.

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