Interest rates explained

An interest rate looks like a small, boring number. 7%. 12%. Who cares? Your future self cares, because over the life of a loan those small numbers quietly decide whether you pay hundreds or thousands of extra dollars for exactly the same thing.

How interest is actually charged

A loan rate is quoted per year, but interest is usually calculated on your remaining balance and charged monthly. Borrow $10,000 at 12% and the first month costs you roughly 1% of the balance, about $100, in interest before a single dollar of your repayment touches the actual debt. As the balance falls, the interest charged each month falls with it. This is why extra repayments early in a loan punch far above their weight: they shrink the balance that every future month's interest is calculated on.

Small rate, big difference

Take a $10,000 personal loan over 5 years. At 6%, the repayment is roughly $193 a month and the total interest comes to about $1,600. At 12%, the repayment is roughly $222 a month and the total interest is about $3,350. These figures are approximate, but the shape is exact: doubling the rate roughly doubles the interest bill. The rate difference looked like pocket change. The cost difference is a return flight to Europe.

Interest on interest

There is a second reason small rates grow into big numbers, and it is compounding. When interest is charged on a balance and you do not clear it, that interest joins the balance, and next period you are charged interest on the interest as well. On a loan you are paying down steadily this effect is mild, because the balance keeps shrinking. On a debt you only pay the minimum on, like a credit card, it is fierce, because the balance barely moves and the interest keeps stacking on top of itself. The same force that slowly builds a savings account works in reverse against a borrower who never gets ahead of it.

The minimum repayment trap

Credit cards show a minimum repayment each month, often a small percentage of the balance, and it is designed to look kind. Paying only the minimum keeps the account in good standing, but it barely touches the principal, so the balance lingers and the interest keeps compounding on it. A card balance paid at only the minimum can take many years and cost more in interest than the original purchases, which is the same mechanism as the term lesson, running against you instead of for you. The move that beats it is simple: pay more than the minimum whenever you can, and aim to clear the balance in full.

Why rates differ between people and products

Lenders price loans by risk. Strong security, steady income and a clean repayment history mean a lower chance the lender loses money, so they charge less. No security, patchy income or missed payments in your file mean a higher chance, so they charge more. This is also why home loans are cheap, personal loans are mid priced and credit cards are expensive: the lender's risk climbs at each step.

The rate behind the rates

Underneath every loan in the country sits the cash rate, set by the Reserve Bank of Australia. When the RBA moves it, lenders move too, which is why a mortgage repayment can rise without the borrower doing anything at all. If your loan has a variable rate, budget for the possibility it goes up. If it is fixed, know when the fixed period ends, because that is when the surprise arrives.

What this looks like in your life

This is not abstract, even now. The interest your savings account pays you runs on exactly the same rule as the interest a loan charges you, just in your favour, which is why the savings topic and this one are two sides of one coin. And the first place most people feel a rate bite is a phone or a card, where a balance carried from month to month quietly grows. Reading the rate, and multiplying it across the whole balance in dollars, is a habit you can start on the very next thing you are tempted to buy on credit.

The next lesson takes the same rate and shows what the length of a loan does to it, and the savings and investing topics show the same compounding working for you instead of against you.