Interest rates are involved in nearly all formal lending and borrowing transactions, including mortgages, the cost of debt on credit cards, investment growth in a savings account or share certificate, amortization of long-term assets, and more. Understanding how they work can help people make better financial decisions, whether they’re deciding to take out a loan, save for the future or invest in assets.
A variety of factors determines the magnitude of an interest rate, from personal factors like creditworthiness to market-driven factors such as inflation and monetary policy. In general, higher interest rates raise the cost of borrowing, and lower ones decrease it. This in turn impacts the overall economy and can influence spending and investment patterns.
In most cases, the amount of money a borrower must pay back exceeds the original sum borrowed, because lenders want compensation for the loss of use of the funds during the time period when the money is being paid back. This amount is known as the interest rate and is usually represented on a graph with the actual principal on the vertical axis and the interest rate or term to maturity on the horizontal axis (in this case, the number of years).
It’s important to note that there are two types of interest rates: nominal and real. The nominal rate ignores inflation and bank fees, while the real interest rate does, to give a more accurate picture of the true cost or return on a loan or savings. The real rate also includes a risk factor, which represents the probability that a lender will not be fully repaid.