Interest rates play important roles in our lives, whether we’re securing a mortgage or building savings. Understanding how they work can help you make more informed financial decisions.
An interest rate is a metric that represents the price paid by borrowers for access to funds and the return on investment for savers and lenders. It is often expressed as a percentage of the principal amount of a loan, credit card balance or other account. It may also be calculated on a daily, monthly, quarterly or yearly basis. The type of compounding used, the number of periods in a year and other factors can all shape the total cost or return of a debt instrument or savings vehicle.
The basic concept is that the value of money available today is less than the same amount in the future due to inflation and opportunity costs (the potential earnings that could have been earned if the funds were invested elsewhere). Lenders charge interest to cover these losses, plus some additional profit for taking on the risk of not being fully repaid.
Different types of interests rates exist, and each has its own pros and cons. For example, fixed rates are set at the time of a loan and do not change over the life of the loan, while variable rates fluctuate up or down depending on market conditions. Loan repayment terms, down payments and other factors can also impact interest rates. For instance, longer loan repayment terms may require higher interest rates because of the increased risk that a borrower will default on their loan.
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