Interest rates: what they are and how they work


What is an interest rate?

An interest rate is the cost you are charged for borrowing money or the payment you receive for depositing or lending money.

You hear about interest rates all the time: an offer for a savings account flashes on your screen with a title with an interest rate of 0.4%, or a real estate agent says you might want to buy a home because interest rates are at record highs.

These interest rates all actually translate into the price of money. They dictate how much someone will pay to borrow money from you or how much you will pay to borrow it from someone else.

Whether you want to deposit or borrow money, your research should include studying a few key factors to make sure you get the best deal. One of the most important pieces of the puzzle is the interest rate.

How Interest Rates Work

When you earn interest on your deposit accounts, the bank or credit union pays you. In return for these interest payments, the financial institution will use those funds by lending them to someone else and charging them interest. The bank will charge a higher rate for this loan. Think of your interest payments as a fraction of that income.

How interest rates are determined

Interest rates on many financial products are linked to benchmark interest rates that serve as regulators of economic growth and inflation. Simply put, lower benchmark interest rates encourage borrowing and spending activities that fuel the economy. Higher benchmark rates help curb speculative activity that could fuel inflation.

For short-term products like savings accounts and CDs, the federal funds rate plays a central role. The federal funds rate is set by the Federal Reserve, which meets eight times a year to assess the health of the economy and consider any need for interest rate changes. For long-term loans and credit products, the rate the US government pays to borrow money is the key benchmark.

You also play an important role in setting the interest rate if you borrow money. When the banks deem you to be a greater risk as a borrower, the interest rate will increase to reflect the institution’s heightened fears that you may not be able to repay the loan. If your credit score is lower or if you can only afford a small down payment, you will pay a higher interest rate than a borrower who has a long, strong credit history with a large sum of money on loan. drop off.

How to earn interest

There is a wide range of banking products that can help you earn interest: a few checking accounts, savings accounts, money market accounts, and CDs. You will likely find higher interest rates with accounts with additional restrictions. For example, you will earn more by locking your funds in a 3-year CD than by depositing them in a checking account which allows unlimited withdrawals.

No matter what type of account you want to open, online banks and credit unions tend to offer the most competitive options for earning interest. Without the overhead of physical branches, online banks can afford to pay their customers more. Online banks are as secure as physical banks. Credit unions, on the other hand, are nonprofit institutions owned by their members, and they can return profits to members in the form of higher interest rates for savers and lower interest rates. for borrowers.

How Interest Works When You Borrow Money

When you borrow, the lender gives you a sum of money, and this number – called the principal – accumulates interest, which increases the total amount you pay over the life of the loan.

For example, suppose you borrow $ 200,000 to buy a house and the terms include an interest rate of 4%. Each month, part of your payment goes to principal – that initial amount of $ 200,000 – while another part is made up of a month’s interest that accumulates from that 4% annual rate. Over the life of a 30-year loan, the interest rate makes a big difference in the overall amount you pay back.

It is important to note that some interest is fixed and the rate will never change over the course of the loan. In other cases, the interest is variable, which means your rate will rise or fall with the market.

APR and APY vs interest rate

Interest rates play a vital role in your finances. However, to get the full picture of what you earn or what you pay, you focus on two acronyms: APR and APY.

  • APY stands for annualized percentage return. This number reflects the difference that compounding can make in your ability to make money with your savings. This is the interest you earn on your interest, provided you reinvest it. If you are comparing savings products, APY should be your goal with one exception: if you plan to withdraw your interest payments on a regular basis. If you are retired or live on a fixed income and plan to use the interest as regular income when it arrives in your account, it will not benefit from funding.
  • APR represents the annualized percentage rate. It reflects the total cost of the loan including the interest rate and fees incurred over the life of the loan. There can also be an important difference. For loans with high initial or ongoing fees, the interest rate could be 3.5% while the APR could be 4.5%. Use this APR as a key point of comparison to understand how to improve your borrowing experience based on your overall budget.

About Wanda Reilly

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