Interest rates play critical roles in the cost of debt for borrowers and the profitability of savings vehicles. Understanding how they work is key to making sound financial decisions, managing debt, and building savings.
Essentially, interest is the price charged by lenders to borrowers for the use of funds (the principal) and can be calculated as a percentage of the principal or as a periodic rate that is compounded daily, weekly, monthly, annually or any other time period. Interest rates are important because they determine how much you will pay on any loan, credit card, or investment.
Different types of loans come with different risk profiles, which impact the interest rates that apply to each. For example, mortgages are secured by real estate and therefore have lower interest rates than unsecured loans such as credit cards. Additionally, the amount borrowed, the term of the loan and whether the loan is fixed or variable all have an impact on the amount you will owe at the end of the day.
The interest rate is set by the Federal Reserve for short-term loans to banks. However, individual lenders can also influence their interest rates by adjusting how much they charge for borrowing money and credit. Ultimately, the market for money and credit is driven by supply and demand. When there is a high demand for money and credit, the interest rate will be higher; when there is less demand, the interest rate will be lower.