Interest rates are at the heart of many financial transactions. They affect everything from the cost of debt to the return on savings and investments. Understanding how they work can help you make better decisions about borrowing, saving and investing.
A quick definition: interest is the amount paid by one party to another for the use of funds lent or invested. It’s often expressed as a percentage of the principal sum involved in the transaction.
When a person borrows money from a lender, they typically agree to repay that initial sum plus additional amounts that represent compensation for the loan period. The additional repayment sums are called interest.
The exact calculation of interest can vary depending on the type of interest being charged or earned. For example, a bank may calculate daily interest on savings account balances but only pay the interest at the end of each month (365 times per year). The amount of interest that accumulates between payment periods is called accrued interest.
Personal factors can also influence interest rates, such as a borrower’s creditworthiness. Lenders consider things like a person’s FICO credit score and bank statements when deciding whether to lend them money and at what rate. They might also adjust rates based on economic factors. For instance, if demand for consumer loans and credit cards is low, banks and credit unions might lower their rates to attract deposits.
Similarly, when interest rates are low, investment capital tends to move into riskier assets like stocks, which boosts the economy. But when interest rates rise, businesses and consumers are less likely to borrow money or invest, and the economy slows.