Interest rates are critical to your financial health — they dictate how much debt costs and how much money you can earn from certain types of investments. However, it can be difficult to grasp how they work and how they differ. This article is designed to help you better understand this important metric so you can make savvy decisions when it comes to borrowing and saving money.
When it comes to lending, an interest rate is the price paid (or earned) by a lender for putting their money at risk. It’s usually applied over a set period of time, known as the loan or investment term. This is why it’s commonly called the “cost of credit” or “return on investment.”
There are two types of interest rates: fixed and variable. When you take out a loan, the type of rate will determine everything from your monthly payments to how long it takes you to pay off the principal.
Typically, lenders use various factors to determine your interest rate, including your credit score and history, income and spending habits. The overall economy also influences interest rates. During periods of high inflation, the Federal Reserve may raise rates to slow spending, while during times of low inflation they may lower rates to encourage borrowing and economic growth.
When it comes to savings, higher interest rates typically mean more money in your account over time. This is because money that’s available now is worth more than the same amount of money in the future due to inflation and opportunity cost (the potential earnings you could have made by investing the funds elsewhere). However, this doesn’t always apply, and it’s important to compare different accounts and consider your own needs before choosing a savings vehicle.