Interest rates play a role in nearly every financial transaction, from obtaining a home mortgage to earning a return on your savings. Understanding interest rates helps you make smarter decisions that can save or cost you thousands of dollars over time.
An interest rate is the amount paid or earned on a sum of money over a period of time, normally a year. A person or business pays interest when they borrow money from a bank, credit union, or other lender. Similarly, people earn interest on money they deposit into a savings account or certificate of deposit (CD). Interest rates can be fixed or variable, and both types come with different benefits and drawbacks.
The most basic type of interest is simple interest, which takes into account only the principal sum and the interest rate over the loan term. For example, if someone borrows $100 from a bank for one year at 4%, they will owe the bank $110 the next year—$100 for the principal and $10 for interest. Simple interest is most commonly used for short-term loans or investments that don’t compound over time.
Many personal factors influence your interest rate, including your creditworthiness and the amount of debt you take on. Businesses, on the other hand, often consider market and economic trends when setting their interest rates. As a result, it’s important to compare and understand the various interest rates available to you before accepting any offers or making any commitments.