What is an interest rate?

Interest rates are one of those financial terms we hear all the time, in the news, at the bank, in credit card agreements, but let’s be real: they’re not always explained in plain language. So what is an interest rate, and why does it matter?

Whether you’re saving money, borrowing for a car, or paying off a credit card, interest rates affect how much you earn, or how much you owe.

In this friendly guide, we’ll break it all down: what interest rates are, how they work, and how they can impact your money in the real world.

The simple definition

An interest rate is basically the cost of borrowing money or the reward for saving it. It’s expressed as a percentage, and it tells you how much extra you’ll pay (or earn) over time.

For example:

• If you borrow $1,000 with a 5% annual interest rate, you’ll pay $50 in interest after one year (if it’s simple interest).
• If you save $1,000 in a bank account that pays 2% interest, you’ll earn $20 in a year.

That percentage can make a big difference, especially when large amounts or long periods are involved.

Interest when borrowing: what you need to know

When you borrow Money, whether it’s a loan, mortgage, or credit card, you’ll almost always have to pay it back plus interest. That’s how lenders make a profit. Common types of borrowing that include interest:

• Credit cards
• Personal loans
• Student loans
• Mortgages
• Auto loans

Each one may come with different interest rates and terms, depending on your credit score, the loan amount, the lender, and the risk involved.

Interest when saving: how it helps your money grow

On the flip side, when you save or invest money, you can earn interest. This is the bank or financial institution’s way of saying “thank you” for letting them use your money. Common savings tools that earn interest include:

• Savings accounts
• Certificates of deposit (CDs)
• Money market accounts
• Bonds

While savings interest rates are generally lower than loan rates, it’s still extra money going into your budget, so why not take advantage of it?

Fixed vs. variable interest rates

Not all interest rates work the same way — and understanding the difference can help you make smarter choices when borrowing or saving. The two most common types are fixed and variable interest rates.

1. Fixed interest rate

This stays the same for the entire term of your loan or savings. You’ll know exactly what to expect every month—no surprises.

Pros:

• Predictable monthly payments (loan)
• Easy financial planning (loan)
• Protection against increases in the base rate (loan)
• Guaranteed profitability until maturity (savings and investments)
• Ideal for those seeking security and predictability (savings and investments)
• Protection against drops in market rates c

Cons:

• Initial rate may be higher than the variable rat (loan)
• No benefit if market rates fall (loan)
• Less flexibility for extra repayments – in some contracts (loan)
• May yield less if rates rise (savings and investments)
• Less flexibility to withdraw early – as in term deposits (savings and investments)
• Does not keep up with inflation if it rises above the contracted rate (savings and investments)

2. Variable interest rate

This can go up or down based on changes in the market or an index rate (like the federal funds rate in the U.S.).

Pros:

• Can start with a lower rate (loan)
• Possibility of paying less if rates fall (loan)
• Usually allows extra payments or early repayment without penalties (loan)
• May yield more if interest rates rise (savings and investments)
• Flexibility of access – as in savings accounts with variable rates (savings and investments)
• More sensitive to market conditions (savings and investments)

Cons:

• Payments can increase unexpectedly (loan)
• Harder to predict long-term costs (loan)
• Direct impact of changes in the Central Bank’s base rate (loan)
• Profitability may fall if rates fall (savings and investments)
• Difficult to predict how much you will earn in the long term (savings and investments)
• May not be worth it if there are frequent fluctuations (savings and investments)

If you’re borrowing money, choosing between fixed and variable interest can make a huge difference. Be sure to understand what kind you’re getting before signing anything.

Interest rate vs. comparison rate: what’s the real cost?

When you apply for a loan in Australia, you’ll often see two rates: the interest rate and the comparison rate.

So, what’s the difference?

Interest rate is the base cost of borrowing money, expressed as a percentage.

Comparison rate includes the interest rate plus most upfront and ongoing fees, giving you a better idea of the true cost of the loan.

Example:

• Lender A offers a 5% interest rate and no fees → 5% comparison rate
• Lender B offers a 4.5% interest rate but adds $500 in fees → 6% comparison rate
• Even though Lender B has a lower interest rate, Lender A may be cheaper overall.

Always check the comparison rate when comparing loan or credit card offers — it’s designed to help you avoid hidden costs.

How interest rates are set

Interest rates aren’t picked at random — they’re influenced by a mix of economic factors and individual circumstances.

1. Central bank

The Reserve Bank of Australia (RBA) sets the official cash rate, which acts as a benchmark for interest rates across the economy. When the RBA raises or lowers this rate, banks usually follow by adjusting their own rates on home loans, savings accounts, and credit cards.

If the cash rate goes up, borrowing becomes more expensive — often used to slow down inflation.

If the cash rate goes down, borrowing is cheaper — encouraging spending and investment.

2. Inflation

Inflation is a key reason the RBA changes interest rates. When inflation is high, rates are often increased to reduce demand. When inflation is low, the RBA may cut rates to stimulate the economy.

3. Credit scores

Lenders look at your credit score to decide how risky it is to lend you money. In addition, lenders also look at income stability and debt levels.

If you have a solid credit profile, you are more likely to qualify for loans with lower interest rates. A lower score can lead to higher rates because the lender is taking on more risk.

How interest affects your debt

Let’s talk real life. If you carry a credit card balance with a high interest rate, your debt can grow fast—even if you’re making minimum payments.

Example:

• $2,000 balance at 20% interest
• Minimum monthly payment: $50
• It could take years to pay off—and you’ll end up paying hundreds in interest.

That’s why it’s smart to pay off high-interest debt as soon as possible and look for balance transfer offers or personal loans with lower rates.

Tips for managing interest

Interest can work for or against you, depending on how you manage it. Here are a few smart tips:

1. Pay more than the minimum

Especially on credit cards. Even small extra payments help reduce interest over time.

2. Refinance when rates drop

If interest rates fall, consider refinancing your mortgage, auto loan, or student loans to lock in a better deal.

3. Shop around

Don’t accept the first rate you see. Compare lenders, ask about promotions, and use online tools to find the best option.

4. Use interest to your advantage

Put your emergency fund or savings into accounts that earn interest. Let your money work while you sleep.

Final thoughts

Interest rates are everywhere, even if you don’t always notice them. Whether you’re saving for your future or financing a big purchase, understanding how interest works gives you the power to make smarter money moves.

The next time you’re faced with a loan, credit card, or savings offer, you’ll be ready. Look at the rate, know what it means, and decide whether it’s working for you, or against you.

Quick recap

• Interest rate = cost of borrowing or reward for saving
• Fixed = stays the same; variable = can change
• Simple interest is on the principal only; compound interest grows faster
• Higher credit scores = better interest rates