A basic financial concept that figures into everything from mortgages and credit cards to investments and savings accounts. Interest rates are a critical component of various financial instruments and transactions, and they are always changing. Understanding what affects them can help individuals make the best choices about how to manage their money.
Interest is a form of compensation paid by lenders to borrowers and investors for the use of their funds. It’s usually expressed as a percentage of the principal amount of the loan or investment, and it is applied over an agreed-upon time period, called the term. The rate at which interest is paid or earned depends on several factors, including the supply and demand for credit, the inflation rate and government monetary policy.
Generally, higher interest rates mean more costly loans and investments while lower rates mean cheaper loans and investments. In addition, the economy plays a role in interest rates because when the economy is strong, more people have jobs and are able to pay their debts, so more lending institutions will want to lend money.
Different types of loans have different interest rates, with fixed and variable rates among the most notable. Generally, fixed rates have higher initial rates than variable rates because lenders take on more risk by locking into a set rate at the outset. However, if market interest rates decline over the life of the loan, a borrower might save money by opting for a variable rate instead of a fixed one.