Interest rates play a big part in your financial life, whether you’re borrowing money or saving it. Understanding exactly how they work is crucial to making smart financial decisions and hitting your goals.
The most basic definition of an interest rate is a percentage of the principal borrowed or deposited. This proportion is expressed in a period of time, usually on an annual basis, though it can be calculated for any number of periods. There are also two basic ways in which interest can be calculated: simple and compound. Simple interest is based on the initial sum borrowed or deposited, while compounding is based on a continuously growing calculation of the principal and interest.
There are many factors that influence the amount of interest you pay, including your creditworthiness and the economy. Lenders will look at your FICO credit score and other financial documents before deciding what kind of interest to charge you, and they’ll take into account the strength of the economy when setting rates for home mortgages and business loans.
One of the most important factors in calculating an interest rate is inflation. Nominal interest rates don’t take inflation into account, but real (or effective) rates do. Inflation adjusts the purchasing power of money over time, so a nominal interest rate that doesn’t take inflation into account will actually end up costing you more than if you had paid a real interest rate. This is why it’s important to compare nominal and real interest rates when shopping for loans and investments.