Interest rates influence how much it costs to borrow money and how much money you can earn from savings accounts and some types of investments. Understanding how interest rates work can help you make better financial decisions and manage your money.
When the cost of borrowing increases, it can slow economic activity. But when rates are low, it can stimulate borrowing and spending, which may benefit your financial situation.
The amount of interest you pay depends on how long you borrow the money, and whether it’s a fixed- or variable-rate loan. Generally, fixed-rate loans have lower interest rates than variable-rate loans.
A variety of factors can influence interest rates, including economic conditions, inflation, and monetary policy (the governing body that sets the amount of money that banks lend to each other). High rates can make borrowing more expensive, while low rates can encourage spending and investment.
There are two different kinds of interest: simple interest and compound interest. Simple interest is calculated by multiplying the principal amount times the interest rate per period, which is usually a year. For example, if you borrowed $100,000 at a simple interest rate of 4%, you’d be obligated to repay the bank $110,000. Compound interest rates take account of the fact that the interest is paid periodically throughout the year.
Some lenders may be concerned that they won’t be repaid, so they add a risk factor to the simple interest rate. For example, if they believe that there’s a 5% chance that the loan won’t be repaid, they would increase the simple interest rate by 5%.