Interest rates play critical roles in both personal and business finances. They determine how much it costs to borrow money, and they influence the amount of profit you earn from investing. Understanding how they work can help you make better financial decisions and manage your money.
An interest rate is the price you pay, expressed as a percentage, to borrow money. It’s also the reward you get for lending it out. Interest rates are the primary method by which banks and other lenders make a profit. Whether you’re taking out a mortgage, saving for retirement, or buying a car, you’re affected by interest rates. The rate you pay (or earn) on those investments can save or cost you thousands, or even tens of thousands, of dollars over the life of your loan or investment.
The strength of the economy: The more people there are who want to buy things, or invest their money, the higher the demand for credit and money. When there’s more demand than supply, banks and other lenders can charge higher rates to entice customers to take out loans.
How a lender decides how much to charge: The amount of interest paid is based on several factors, including the borrower’s creditworthiness and the broader economic conditions. Banks also look at how much other lenders are charging to determine what their own rates should be.
How interest is calculated: There are a number of different ways that interest can be calculated, but the most common is called simple interest. It’s based on a formula that combines the amount borrowed, or principal, with the period of time over which the money is lent, or accrued.
About the Author
