Interest rates have a profound effect on the buying power of every dollar in your bank account, the amount you need to save for retirement and the amount you can earn from investments. Knowing how interest rates work is essential for anyone interested in finance, economics and personal finances.
In short, an interest rate is a fee charged for the use of another person’s or company’s money (lending) or asset (saving). The size of this fee is dependent on three factors: principal sum, compounding frequency and length of time.
For example, if a borrower pays back their loan or debt with a percentage of the total amount borrowed called simple interest, they will pay back their original loan plus the amount paid back in interest each period, which is typically a year. However, if they paid the bank a fixed amount of money to hold in their savings account each year, that money would grow over time due to the principle being compounded. This is called compound interest and it is more beneficial to the borrower because the total amount owed and earned is less than what was originally borrowed or saved.
The Federal Reserve sets the federal funds rate, which is used by banks to determine their interest rates on mortgages and other loans. The Fed is one of many central banks around the world and changes to the federal funds rate can have a wide impact on the economy.