Interest rates are central to borrowing and saving, influencing everything from the affordability of mortgages and auto loans to the return on investments. They’re also crucial to the way you create a budget. Understanding how interest rates work can help you make more informed financial decisions that fit your lifestyle and goals.
A key part of the cost of debt for the borrower and the rate of return on savings for the lender, interest is calculated as a percentage of the principal sum borrowed or deposited. It is generally expressed as a decimal number or as a fraction of a year (sometimes called an annualized rate). Simple interest and compound interest are the two main methods for calculating interest, with most loans using simple interest while savings accounts and money market funds use compounding.
Lender policies and macroeconomic trends affect interest rates. For example, if lenders perceive that an economy is experiencing high levels of inflation, they may increase their credit card interest rates or raise deposit account interest rates to discourage excessive borrowing and slow economic growth. The Federal Reserve, the US central bank, sets interest rates and aims to keep them consistent with overall economic health.
For borrowers, understanding how to choose between fixed and variable rates can help you make savvy financial choices that fit your lifestyle and goals. For example, if you think you’ll be able to pay off your loan before interest rates rise significantly, a variable rate may work for you. But if you expect to take on a longer-term loan or need flexibility, a fixed rate may offer the peace of mind that comes with consistency.