Interest rates play a key role in many financial transactions, from personal loans to credit card purchases and savings. Understanding how they work can help individuals take control of their finances, allow professionals to make informed financial decisions and empower businesses to create a budget.
In the simplest terms, interest is a fee charged by a lender or bank for using its money. It is typically expressed as a percentage of the principal amount, and is calculated over a period of time that can be annually or less frequently depending on the type of transaction.
The interest rate set by a country’s central bank (e.g., the Federal Reserve in the United States) is an important determinant of overall economic conditions. A high interest rate discourages consumers from borrowing, and can lead to slow or even negative growth. Conversely, a low interest rate encourages people to borrow and spend, and can stimulate economic activity.
When comparing interest rates between lenders, be sure to consider the effective annual rate which takes compounding into account. This will provide a more accurate representation of the true cost of borrowing or investing.
Another key factor determining the interest rate offered on a loan or deposit is the borrower’s riskiness. Individuals who use their credit wisely and avoid defaulting on their accounts are often able to negotiate lower interest rates than those with poorer credit histories. This is because creditors will want to ensure that they’ll be repaid for the funds they lend or invest.