Interest rates play a big part in the financial lives of many people, from how much it costs to borrow money to the amount of income you can earn on savings and investments. Knowing more about how they work could help you make better decisions about your finances.
Interest is the amount charged, expressed as a percentage of the principal, for the use of borrowed money or assets. Lenders require a rate of return on the funds they lend in order to compensate for the time they lose from investing the cash in other transactions and to cover their risk that the borrower will not repay what is owed. Borrowers typically seek low interest rates to pay less for what they borrow; investors and savers prefer higher rates of return to earn more on the money they invest or deposit in accounts or other assets.
The relationship between the various interest rates that lenders or issuers may charge and the terms of the loans or bonds can be viewed as a curve, with the general shape being one of a rising slope. This typical shape reflects the premium that investors demand for taking on the risk of holding longer-term debt, which pays a higher yield than shorter-term bonds.
Individual lenders and creditors set their own interest rates, based on factors such as the borrower’s credit history and type of loan or the current state of the economy. They may offer fixed or variable rates, with each offering its own pros and cons. The cost of a mortgage, car loan or other debt often is advertised with an annual percentage rate (APR), which more accurately reflects the true costs associated with borrowing.
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