Interest rate is a financial concept that affects everyone’s life in countless ways. Consumers consider it when purchasing something expensive, investors follow it as a signal about market conditions and businesses, and the Federal Reserve adjusts it to keep the economy running smoothly. Understanding what it means and how it works can help you make smarter financial decisions and manage your personal and business finances.
In general, the higher the interest rate, the more it costs to borrow money. This is because the lender must charge extra in exchange for letting you use their assets. Interest rates are often tied to inflation, which explains why they tend to rise and fall together. Low interest rates are generally good for economies because they stimulate spending, which helps companies grow and people buy things. However, they can also lead to market disequilibrium where demand outstrips supply, causing prices to rise.
When it comes to investing, the interest rate determines how much you earn from a given investment or savings account. There are two types of interest: simple and compounding. The former is calculated using a simpler formula that applies the percentage only to the principal amount owed, whereas the latter accounts for all of the principal plus the interest accrued over time.
Similarly, there are different types of loans and credit products with fixed or variable interest rates. For example, mortgages typically have lower interest rates than credit card debt because they are secured by a home or other property. This helps reduce the risk to lenders and may make them more willing to lend money or extend credit. A variable rate, on the other hand, is less predictable and can make budgeting more difficult.