Interest rates are a critical part of the financial system and influence everything from how much it costs to borrow money to the return on savings and investments. Understanding what interest is and how it works can help individuals make savvy financial decisions and build wealth.
Interest is the price you pay to borrow money or earn compensation for lending it. It’s typically expressed as a percentage of the principal amount of the loan or investment.
Different types of interest exist, and each has its own benefits and drawbacks. For example, a fixed interest rate means that the amount you’ll pay or receive over the course of the loan won’t change, no matter what happens to market interest rates. This consistency may make budgeting easier and protect borrowers from rising rates. But it also means borrowers won’t benefit if market rates fall during their loan term, and savers won’t earn more interest than they would with a variable rate.
There are also different ways to calculate interest, including simple and compounding. And there are nominal and real interest rates, with the latter accounting for inflation to provide a more accurate picture of how much you pay or earn. In addition, how your rate is applied to the principal varies by lender and type of account. Read on to learn more about the many factors that shape interest rates and how they work across the economy and personal finances.