Whether you’re shopping for lenders in the pursuit of a loan or you’re comparing investment vehicles for your hard-earned money, you'll likely want to find the best interest rate for your transaction. If you’re paying the interest on a loan, you’ll want the lowest rate possible, but if you’re earning the interest on an investment, you’ll want the highest rate possible. Regardless of which side of the “interest fence” you’re on, interest rates are key considerations for borrowers and lenders. The advantages and disadvantages of interest rates don’t conform to a standard model that works for everyone because of the intricacies of their profit-and-loss applications, although some basic principles apply across the board.
Interest rates provide their own fair share of advantages and disadvantages for lender and borrower alike. In various situations, raising or lowing an interest rate could prove to be advantageous for both parties.
What Are Interest Rates?
In the world of banking and finance, “interest” represents the rate a lender charges a borrower for extending a loan to the borrower. Lenders comprise a diverse group, which includes individuals, banks, corporations, municipalities and credit card companies. On the flip side, interest also represents the amount an investor earns on an investment. Interest rates are typically expressed as a percentage or portion of the amount of money that is borrowed or invested.
Types of Interest Rates
The different types of interest rates can sometimes even keep financial professionals on their toes while trying to understand them. Some types that may be most familiar include simple and compound interest rates as well as fixed and adjustable interest rates. But there’s a type of benchmark interest rate that has a trickle-down effect on most of the other types – the prime interest rate. Also called the prime lending rate, the prime interest rate is a benefit that the most creditworthy people enjoy. Banking customers, for example, who have the best credit scores can get the lowest interest rates for loans the bank makes. Lenders typically look to the prime lending rate as a starting point from which they determine their interest rates for customers with varying credit scores.
Simple interest is applied toward the original amount of a loan, also called the principal amount, and compound (or compounded) interest is applied toward the unpaid principal amount plus the accumulated interest from prior periods.
Fixed interest rates do not change over time, but adjustable interest rates fluctuate (or adjust) over time. An adjustable rate mortgage (ARM) is an example of this fluctuating interest rate. Interest rates on ARMs can vary widely, depending on the terms of the loan.
Advantages of Interest Rates
Interest rates hold advantages for both borrowers and lenders. Fixed interest rates are attractive to borrowers who want to know exactly what each of their loan payments will be, without regard to market fluctuations. If interest rates rise, the borrower who has a fixed-rate mortgage is locked into the lower interest over the life of the loan instead of having to pay the higher interest rate of newer loans. If interest rates decrease, lenders have the advantage by making more money from their customers with higher-interest rate loans.
Mortgage loans with an adjustable interest rate often help would-be homeowners buy a house and begin repaying their loan at a lower interest rate. Even though the interest rate may increase on ARM loans, it typically doesn’t adjust until after the first year of payments. By then, new homeowners may have paid down other debt so that they can better manage their higher mortgage payments.
Although simple interest is a source of unearned income, investors like to earn compound interest. Compared side by side on an equal investment amount, compound interest earns the investor more money than simple interest.
Disadvantages of Interest Rates
The advantage of a particular interest rate for some people may also be disadvantageous to others if there’s a significant change in the economy. The same low interest rate that lures borrowers can drive away potential investors because of a low return on their investments.
When interest rates rise, existing borrowers with lower-interest loans have the advantage. But potential borrowers are at a disadvantage in this environment because high interest rates may drive up the amount of their monthly mortgage payments, for example, beyond the threshold they can afford. This also puts many lenders in a lurch if they don’t have a large-enough borrowing pool from which they're earning interest. Business owners often have to raise the prices of their goods and services when interest rates rise so they can cover the cost of their business loans, which makes the overarching effect of high interest rates disadvantageous for consumers.