Interest rates play a critical role in how much you pay for loans, such as car or mortgages, and how much you earn on investments like savings accounts. It’s important to understand how they work so you can make smarter financial decisions and manage your money.
There are several factors that affect interest rates, from the amount of risk involved to the purpose of the loan or investment. For example, a mortgage may have lower rates than personal or credit card debt because it is secured by the borrower’s property, which can be sold to cover debt payments in the event of default. The duration of the loan or debt also impacts rates, with longer-term loans generally having higher interest rates than shorter-term loans.
Inflation rates also influence interest rates, with central banks raising rates during periods of high inflation to discourage borrowing and spending and lowering rates during economic downturns to encourage lending and investment. These policies affect the cost of borrowing and the yields on savings, influencing everything from business investment to consumer buying habits.
The way in which interest is calculated is also a factor, with the most common methods being simple interest and compound interest. In the real world, you’re more likely to encounter annual percentage rate (APR) calculations for loans, which include both the principal and interest amounts to give a full picture of the true costs of financing. For example, a car dealer might only quote monthly payments and total price when discussing the cost of a new car, but the APR includes both the interest on the loan and the fees charged, such as sales tax and registration fees.