Interest rates affect your debt costs, savings, and investments. They’re a central part of the economy. But many people don’t understand how they work.
The interest rate is the cost to borrowers and the return to lenders for their money, expressed as a percentage of the principal amount borrowed or lent. It can be calculated with either simple or compound interest. A basic rule of thumb: The higher the interest rate, the more it will cost to borrow.
Lenders use several different approaches to decide what interest rates to charge or pay, depending on their business models and the state of the economy. Generally, interest rates are driven by the willingness of consumers, businesses and governments to save or spend more than they take in as revenues. The rates are also affected by the economy’s inflation rate and by credit-scoring systems.
For example, when prices rise, the real annual interest rate earned on a savings account is lower than the nominal (advertised) annual interest rate. This is because the real interest rate takes into account both bank fees and inflation. It is also influenced by the amount of money you have in the account, and the length of time it stays in the account. This is why it is important to comparison shop and understand the terms of a loan or deposit. The interest you pay or earn can add up quickly, so it’s worth taking the time to understand your options.
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