Interest rates are one of the fundamentals of the financial system. They influence the buying power of money, how much we pay for loans, and what we earn on savings. Understanding how they work may help you make better financial decisions.
Borrowers consider them when choosing loans, while savers keep an eye on them to make the most of their money. The Federal Reserve adjusts them to keep the economy running smoothly. The state of interest rates can make or break thousands, even tens of thousands, of dollars over the life of a mortgage or car loan.
There are different types of interest rates: fixed and variable, for example. Fixed interest rates remain the same over the life of a loan, which can simplify budgeting and provide stability, but can also mean that borrowers won’t benefit if market rates fall after they lock in their rate, or that savers won’t earn more if market rates rise during their deposit term.
The interest rate that a borrower pays or earns is usually expressed as a percentage of the principal sum, and it’s often compounded over time. Simple interest is calculated by multiplying the annual rate by the total amount owed or earned, while compound interest takes into account the fact that interest is added to the principal sum each period, so a higher interest rate will result in greater earnings over the long term.
The actual rate you pay or earn can be further complicated by factors such as inflation and bank fees. The nominal interest rate — the advertised interest rate on savings accounts and loans — ignores these factors, while the real interest rate includes them to give a more complete picture of the return or cost you’re experiencing.