What Are Three Types of Interest Rates?

The type of interest rate attached to your car loan, mortgage or student loan can dramatically change the amount of money you pay back on the principal: the original amount borrowed. Understand the calculations of some key types of interest rates to make wiser investment and borrowing decisions.

Significance

Interest rates and the U.S. economy work side by side, so to speak, to control inflation by impacting your decision to spend and borrow money. For example, when interest rates are high, consumers borrow less. A $10,000 loan with a 5 percent interest rate, regardless of the type of interest attached, costs more than a $10,000 loan with a 6 percent interest rate. The increased interest rate reduces borrowing, which, in turn, reduces spending on large items such as houses and cars. Less spending reduces the overall demand of goods and services in the economy, thereby driving down prices. Low interest rates increase borrowing, increase the demand for goods and services and drive inflation.

Simple Interest Rates

Simple interest rates are calculated on the principal amount borrowed. For example, suppose you take out a loan for $10,000 with a simple interest rate of 1 percent. At the end of the first month, you would own $100 in accumulated interest. In all the subsequent months, you would pay interest only on the remaining principal. Interest does not accrue on interest debt accumulated. Using the same example, suppose after three years, you paid down your loan to $5,000, with a remaining principal of $4,500 and an accrued interest debt of $500. The 1 percent simple interest rate would apply to the $4,500 principal. You would owe $45 in simple interest.

Compound Interest Rates

Compound interest applies to both the principal amount borrowed and any accrued interest debt. Suppose you had a loan for $10,000 with a compound interest rate of 1 percent. After three years of payments, you would owe $5,000, with a remaining principal of $4,500 and accrued interest debt of $500. Compound interest applies to the entire $5,000. You would owe $50 in compound interest when your entire debt, including the principal, totaled $5,000.

Variable Interest Rates

Variable interest rates change over time and are affixed to the interest rate index. Most interest rates commonly encountered, including rates attached to car and home loans, are fixed and do not change over time. According to LendingTree, two indexes for determining variable interest rates are Treasury Constant Maturities and Cost of Funds indexes. Variable interest rates provide the opportunity to take advantage of dropping rates. On the other hand, the inherent volatility may not be suitable for borrowers looking for the stability fixed interest rates provide.