Understanding interest rates is essential for anyone managing their finances. From securing a mortgage to building savings, every financial instrument has unique interest rate dynamics that affect the true cost and return on investment.
An interest rate is the percentage of principal paid or earned over a specific period, typically one year. Whether you’re borrowing money or investing in an asset, the amount of interest due depends on three key variables: the rate, the principal sum and the compounding frequency.
When it comes to borrowing, higher interest rates make credit more expensive, reducing consumer spending and slowing economic growth. In contrast, lower interest rates make loans and savings more affordable, encouraging investment and boosting aggregate demand.
Ultimately, interest rates are driven by the relationship between supply and demand for money. The Fed is responsible for adjusting interest rates to maintain this balance.
However, there are also many other factors that influence the interest rates we pay and earn. Some are personal, such as the creditworthiness of an individual. When banks and other lenders assess a person’s creditworthiness, they look at things like FICO credit scores, bank statements and other financial documents to determine their risk profile.
Other factors are macroeconomic, such as inflation and monetary policy. Inflation is a result of excess spending by businesses and consumers, while monetary policies are driven by the need to maintain stable prices. For example, when the Fed raises interest rates to control inflation, they also increase the cost of capital for businesses and individuals.
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