Interest rate is a key concept that influences many financial decisions and activities, from how much it costs to borrow money to how much you can earn on savings or investments. Understanding how rates work is essential to making sound financial decisions.
The interest rate is a percentage of the principal, or main amount, that debtors must pay lenders in return for the use of their funds. The idea is to compensate the lender for the loss of income that could have been generated by investing the borrowed money during the term of the loan. Interest charges help ensure a fair balance of risk and reward between lenders, savers, and borrowers.
When interest rates are high, it becomes more expensive to borrow money and can slow economic activity. But when rates are low, it’s easier to obtain a loan and can stimulate economic growth by providing more money for business investment.
Interest rates are set by central banks or decided by market forces, and they vary depending on factors such as inflation, economic policy, and international political and economic events. They also depend on the type of debt: mortgage loans, for example, typically have lower rates than credit card or car loan debts, because the collateral that backs them reduces the lender’s risk. Also, fixed-rate loans have the advantage of being predictable and easier to budget for. In contrast, variable-rate loans have the disadvantage of being more vulnerable to sudden market changes.