Interest rates affect both the cost of debt and the growth potential of savings vehicles. Understanding how these rates work may help save you money on loans and make your investments more lucrative.
An interest rate is the amount paid or earned on a loan, deposit or investment, calculated as a percentage of the principal sum. It is used in almost all formal lending and borrowing transactions. When borrowers borrow money, interest charges increase the cost of their debt; conversely, when depositors earn interest, they gain more purchasing power for their savings.
The amount of interest paid or earned depends on several factors, including the length of a loan term, compounding frequency and whether the rate is fixed or variable. Choosing the right terms and carefully comparing rates can save you thousands on your mortgage or credit card balance, or boost the return on your savings.
While there are many factors that affect the interest rate (including government policy and inflation), the ultimate effect is determined by supply and demand for money and credit. When there is a surplus of demand, lenders will raise interest rates; when the demand is lower, they will lower them.
A person’s or company’s liquidity preference and taxation also play a role. People prefer to have their resources available in a form that can be quickly exchanged for cash, while businesses may wish to defer the expense of capital goods until they are fully utilized.
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