Interest rate is a key factor in financial decisions, from the cost of borrowing to the growth potential of deposits. Understanding this key concept may help you save money on loans and maximize your return on savings.
The interest rate is the percentage that dictates the amount you pay or earn on a loan, credit card or deposit account. It’s typically expressed over a specified period, known as the interest rate term. The rate can be fixed or variable.
There are multiple factors that shape the total cost of debt and the return on an investment, including compounding frequency, loan terms and whether a rate is fixed or variable. Comparison shopping and understanding these factors can help you make smarter borrowing and saving choices.
In general, money that’s available today is worth more than the same amount of money in the future due to inflation and opportunity costs (the lost earning power of the money). Lenders charge interest to compensate for this loss of value. In addition, they must also cover the risk that borrowers won’t repay their debts.
Consumers should look at effective annual rates rather than the headline-grabbing nominal interest rate when comparing offers from different lenders. The effective rate takes into account fees and tax implications. For example, a loan that compounds twice yearly will have a higher effective interest rate than a similar loan that compounds annually because the compounding frequency is greater. The same is true for deposit accounts such as savings and money market accounts (MMAs) or certificates of deposit (CDs). A CD that compounds once a year has a lower effective interest rate than a similar CD that compounds twice a year.