Interest rates shape the financial landscape and should play a role in any money decision, whether it’s securing a loan or saving. They can make or break your ability to afford certain loans, impact how much you’re able to earn from investments and even affect the buying power of every dollar in your bank account. Understanding interest rates is a crucial step in becoming financially literate, improving your finances and making smart decisions about how to manage debt or save for the future.
The interest rate is the amount a lender charges a borrower for borrowing its funds. This is the principal’s cost for using credit or investment capital, and it is typically based on a formula (see below). For example, if you take out a $100 payday loan with repayment due in two weeks, you would pay a fee of $15 to the lender – which is equivalent to an annual percentage rate (APR) of about 400%.
There are different types of interest rates, such as simple and compound, which vary based on the loan type, amount borrowed, repayment period and the lender’s risk profile. For example, a mortgage will typically have lower interest rates than a credit card. In addition, the level of investment risk – or “maturity risk premium” – is taken into account in the interest rate calculation.
When rates are high, they tend to reduce the affordability of mortgages, auto loans and other forms of debt. But low rates can boost the attractiveness of savings accounts, certificate of deposits (CDs) and other deposit investments.
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