Interest rates play a key role in our financial lives, impacting the cost of borrowing and the return on savings. Understanding how interest rates work can help you make informed decisions about taking out loans, saving and investing.
In simple terms, interest is the price you pay to borrow money or the compensation you receive for lending it. Typically expressed as a percentage of the principal amount, it is calculated and applied over a specified period of time (usually a year). The rate can vary widely, depending on several factors that you can control or not — such as your creditworthiness and the size of the loan or deposit amount.
For example, a larger loan amount generally poses more risk to the lender and may attract a higher interest rate than a smaller one. Additionally, the frequency of compounding and the loan term also affect interest rates. For example, savings accounts and certificates of deposit (CDs) with longer term durations often earn a higher rate than shorter-term ones.
Another factor that influences interest rates is inflation. When inflation is high, interest rates are usually higher to slow spending and economic growth; when inflation is low, interest rates tend to be lower to encourage borrowing and investment activity.