Interest rates play a big role in how much it costs to borrow money and how much you can earn from certain investments. Understanding what interest rates are, who sets them and how they work can help you make smarter financial decisions.
In short, interest is the price you pay for borrowing money, whether it’s a home mortgage, credit card or other type of debt. It is calculated as a percentage of the principal, or original amount borrowed. The higher the interest rate, the more it costs to borrow and the more profit a lender makes.
Generally, lenders set the interest rates they charge based on a number of factors including risk, liquidity, opportunity cost and time. For example, a longer-term loan or debt is typically more expensive than a shorter-term one because the risk of default increases and the opportunity to invest the funds in other assets reduces over the longer period.
Other factors that influence interest rates include the economy and inflation. When inflation is high, central banks usually raise interest rates to slow consumer spending, which can cause the economy to overheat. They also raise rates to encourage saving, which helps keep prices stable and helps people preserve the purchasing power of their savings. This can also boost the income of savers and retirees, who rely on fixed income like Social Security or pensions.
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