Interest is an essential component of borrowing and saving money. It affects how much it costs to buy something with debt or how much we can earn on savings accounts and certificates of deposit (CDs). Interest rates are influenced by many factors, from the Federal Reserve’s target rate to a lender’s creditworthiness and market conditions. Understanding the dynamic of these rates can help you make better financial decisions and manage your money.
When people borrow money, they must pay a fee to the lender in exchange for the use of the funds. The amount of the fee is called interest, and it is calculated as a percentage of the borrowed amount. This is because lenders must compensate themselves for the loss of opportunity to invest the funds elsewhere.
Depending on the type of loan, it can be calculated in either simple or compound interest. Simple interest is tallied each year only on the original principal, while compound interest adds to the principle each month by calculating the current balance with both the principal and the previous months’ accrued interest. Most loans and savings accounts use compound interest.
Individuals can control some of the factors that influence their interest rates, including their credit scores and personal financial documents. But others, such as the Federal Reserve target interest rate and market conditions, are beyond their control. This combination of variables shapes interest rates and can influence consumer spending, business investment and the overall direction of financial markets.