Interest rates play critical roles in how much it costs to borrow money and the returns on certain types of investments. Understanding how they work can help you make better financial decisions, and understand why they change over time.
Lender policies: Lenders may have their own criteria to determine the rate they offer on loans and credit cards, which can vary from one lender to the next. A lender’s criteria might include factors like a borrower’s credit score, income and the length of the loan or credit card term. In addition, the lender’s policy and the economic trends in the market can affect interest rates offered.
Macroeconomic trends: The economy’s overall health influences the cost of borrowing and the return on investments. For example, when the economy is weak and inflation is high, it’s more expensive to borrow and invest money. On the other hand, a low-interest-rate environment often stimulates consumer spending and business investment.
Calculations: There are two main interest-rate calculations: simple and compound. Simple interest is calculated by a percentage of the principal amount owed. For example, if you borrowed $1,000 at 5% for a year, you would pay $50 of interest ($100 x 0.5). Compounding interest is more complicated, as it takes into account the principal amount plus any accumulated interest. It is a more accurate representation of how much you will receive from a loan or investment over time.
Another important distinction is the real interest rate, which considers inflation. To calculate the real interest rate, you need to know the annualized inflation rate, the expected risk of non-repayment and the nominal interest rate.