Interest rates play critical roles in our lives, from how much it costs to borrow money to how we earn on savings and investments. Understanding how they work can help you make better financial decisions about borrowing, saving and investing.
When we borrow, the principal amount of what we owe grows with time because of the interest charge. Interest is often calculated as a percentage of the principal. This means that, for example, if we borrow $200,000 and the loan agreement states a simple interest rate of 4%, we will pay back $240,000 plus $4000 in interest charges (the principal will be $208,000).
An alternative way to think about interest is as a “cost of capital”: how much it costs a business to finance itself. This is why interest rates are closely watched by investors.
Generally speaking, higher interest rates make it more expensive to borrow money, which can slow economic activity. Low interest rates, on the other hand, make it cheaper to borrow money and can encourage economic growth.
While many factors affect interest rates, the Federal Reserve sets a key rate that influences other rates throughout the economy. Other interest rates include the prime rate, discount rate, treasury bill yield, risk premium and cost of equity.
Variable interest rates are more common on loans and credit cards because they can change as market conditions change. Typically, variable interest rates decline during periods of slower economic activity to encourage growth and job creation, while they rise when the economy is growing too quickly to control inflation. Fixed interest rates are more consistent and can make budgeting easier. However, they also prevent borrowers from benefiting from falling market rates after they lock in their rate and can make it harder for savers to beat inflation.
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