If you’re borrowing money – whether for a home mortgage, personal loan or credit card debt – you could be asked to choose between a fixed and variable interest rate. Understanding how these two rates differ – and the pros and cons of each — can help you make smart financial decisions that fit your needs.
An interest rate is either the cost of debt for a borrower or the reward for saving. It’s typically stated as a percentage of the principal amount borrowed. This percentage is paid to or earned by the entity lending the money. A lender or saver can be an individual, business or government agency.
There are many economic theories about how interest rates affect savings and spending. Some of them focus on the interplay between the supply of savings and the demand for investment. Others point to the fact that lenders want to be compensated for tying up their money for a period of time, as well as to account for the risk of not being repaid.
When interest rates are low, the cost of debt is cheap and consumer and business spending tends to increase. This can lead to inflation, which is a result of a market disequilibrium where demand exceeds supply. Inflation causes the price of goods and services to rise, which may in turn cause interest rates to rise. Other factors that influence interest rates include the state of the economy and the country’s central bank.