Interest rates play a key role in our daily financial decisions. They determine how much it costs to borrow money or how profitable saving is. Whether you are buying a car, taking out a home loan or investing in savings, understanding how interest works will help you make better decisions.
Interest is the amount charged on loans or earned on investments over time. It’s typically calculated annually and can be expressed as a percentage of the principal sum, or as a percentage of the original investment (e.g., $100 borrowed for two years will yield Derek a total of $110—$100 for the principal and $10 for the interest). In addition to the period of time, the amount of compounding, or how the interest is calculated, also influences how much you pay or earn.
Different types of debt have different risk profiles, and as a result, come with varying interest rates. For example, mortgages are secured by real estate, which makes them less susceptible to default than personal or credit card debt. Therefore, they often come with lower interest rates than unsecured loans such as credit cards.
The overall economic health of the economy can also impact interest rates, making it more or less expensive to borrow and save. A stronger economy means higher interest rates, while a weaker one generally results in lower ones. This relationship is illustrated in a graph, with interest rates on the vertical axis and the terms to maturity of bonds on the horizontal. Generally, as the term to maturity gets longer, the interest rate becomes higher.