Interest rates play an important role in many aspects of our financial lives, from the buying power of our money to how much we need to save for retirement. But they’re also a complicated subject that can be confusing.
In simple terms, interest is the amount of money paid on a loan or debt, and the amount earned on a savings account or investment. It is typically expressed as a percentage of the principal, and it is calculated over a period of time, such as a year. The annual percentage rate (APR) used for loans and credit cards is a broader measure that takes all fees into consideration.
The rate of interest reflects the reward a lender receives for deferring consumption of resources until a later date. The opportunity cost is higher over longer periods because the resources cannot be used for other purposes. Therefore, a higher interest rate makes it more expensive to borrow money.
A variety of factors help determine interest rates in a given country, including the economy, supply and demand for money, inflation and monetary policy set by the central bank (e.g., the Federal Reserve in the United States). When interest rates are high, it’s more costly to take out a loan or debt. This can slow economic activity. Conversely, low interest rates make borrowing less expensive and may stimulate growth.
Lenders use various criteria to determine your interest rate, including credit scores, reports and factors such as your income and length of loan repayment term. They may also consider market trends and the current economic environment in determining your interest rate, particularly when offering home mortgages. In addition, they might offer you a choice of fixed or variable rates.