Interest rates are all around us: consumers consider them when buying something expensive, lenders consider them when lending money and market watchers keep an eye on them to see what they can tell about the economy. They are also important to businesses that need to calculate annual budgets and projects. But what exactly are they, and how do they work?
In simple terms, an interest rate is the fee that is paid or earned for borrowing or lending money. Lenders typically charge or receive an interest rate on a loan as a percentage of the principal amount borrowed. Generally, the interest rate is expressed as an annual percentage rate (APR) for loans such as mortgages and credit cards, and as an annual percentage yield (APY) for savings accounts and CDs. The calculation of these rates takes compounding into account.
There are many factors that go into determining interest rates, including personal characteristics of the borrower and the economic climate. The personal characteristics include the creditworthiness of a person or business, which is determined by looking at their FICO credit score and bank statements.
When interest rates are high, it becomes more costly to borrow and consumers may be less likely to spend, reducing demand and potentially fueling inflation. This is the goal of the Federal Reserve when it raises rates. However, higher rates can also present unique opportunities for saving and portfolio rebalancing. Learn more about the relationship between interest rates and other key topics on Select’s blog.
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