Interest rate is a basic concept that figures into our lives in many ways: mortgage rates, the charge on credit cards, the growth of retirement accounts, the amortization of long-term assets, the discount a supplier offers to buyers for paying off invoices sooner, and more. The Federal Reserve adjusts interest rates to try to keep the economy running smoothly.
Interest rates are a reflection of the present value of money, with lower rates making it more valuable to save and invest rather than consume or spend. They also reflect the overall strength of the economy, as businesses and consumers’ desire to spend drive up borrowing and investment and thus push interest rates higher.
Lenders and creditors determine their interest rates by a variety of criteria, including the borrower’s creditworthiness (the likelihood they’ll pay back what they owe) and market rates like the prime rate set by the Federal Reserve. The latter is a key benchmark rate that influences the interest rate charged on home loans, car loans and credit card debts.
The amount of interest charged on a loan is calculated using either simple or compound interest, with the former being the more straightforward method that only takes into account the principal sum borrowed. Compound interest, on the other hand, adds to the principal amount each month, meaning the total repayment sum will be higher than the original loan amount.
The term interest is also used for the annual percentage yield (APY) that financial institutions earn on savings accounts and certificates of deposit (CDs). This differs from a nominal interest rate in that it factors in inflation and bank fees to provide a more accurate picture of the return or cost of an asset or loan.