If you follow the financial news or talk to your friends about finances, you probably hear a lot about interest rates. They’re important to understand, whether you’re saving for the future, borrowing money or investing in assets like bonds. High interest rates make borrowing more expensive, which can slow economic growth, while low interest rates can boost it.
There are different types of interest rates, depending on how they’re calculated and applied. The most common type is simple interest, which applies a fixed amount of principal each period to the sum of what’s owed or earned. For example, if Derek borrows $100 from the bank for two years at a 10% interest rate, he’ll owe the bank $120 when the loan ends: $100 for the principal and $20 in interest.
You may also see savings accounts, certificates of deposit (CDs) and loans advertised with both a nominal interest rate and an effective annual interest rate (EAR). The latter takes compounding into account and includes fees to give you an accurate picture of the return or cost of the investment or debt.
Many factors influence interest rates, including inflation and central bank monetary policies. Higher inflation typically paves the way for higher interest rates, while lower inflation correlates with lower ones. Borrowers’ creditworthiness plays a role, too; those with less-than-stellar credit scores are often charged a higher interest rate than those with great credit. Rising rates can be a boon for savers, who could earn higher returns on their investments; but they can also sting borrowers by making it more costly to take out home or auto loans and carry a credit card balance.