Interest rates are an essential part of our everyday financial lives – we pay them when borrowing money, earn them when saving in a bank account and invest in assets. But what exactly are they, how do they work and why do they matter?
In the simplest terms, interest is the pace at which an amount of money grows. It’s how a lender makes a profit on the money they lend you, for example when buying a car or a house. It’s also a crucial tool for savers, determining how much their money grows over time.
The key reason interest rates matter is that they affect the true cost of borrowing and the reward for saving, impacting everything from consumer spending to corporate investment to the direction of the financial markets. A combination of factors determines interest rates across the economy, including the supply and demand for money, inflation and monetary policy set by the Federal Reserve.
Understanding the different types of interest rates can be challenging, as every loan and savings instrument has its own rate that’s determined by its unique financial characteristics. You’ll also find that many rates are advertised as nominal rates, while others, such as the annual percentage yield (APY) on a savings account, take into consideration inflation and fees for a more accurate picture of return or cost.
Finally, there are multiple ways of calculating an interest rate, with some lenders using a compounding system that combines the principal and the interest due on a monthly basis to determine how much is owed over the course of a year. This is the more common method used by banks and lenders on personal loans.