Interest rates influence how much it costs to borrow money and the returns on savings and investments. Understanding how they work can help you make smart financial decisions about borrowing, saving and investing.
There are many factors that affect interest rates, both personal and economic. Personal factors include your creditworthiness, which lenders consider when deciding to lend you money. Market factors include the supply and demand for money, inflation and the monetary policy set by the Federal Reserve.
When you borrow money, the principal you receive is reduced by the amount of interest paid to the lender. This reduces the buying power of your debt, which is why it’s important to always pay on time.
Lenders may also add a risk factor to their interest rate to compensate for the possibility they won’t be fully repaid. For example, if a lender believes there’s a 5% chance that you won’t repay them, they’ll add a 5% risk premium to the loan’s annual percentage rate.
If you deposit or invest money, the interest earned or paid on that investment is calculated at a certain frequency, such as daily, monthly, quarterly or annually. The interest accumulating each day is called accrued interest, while the interest added to a savings account once per month is known as compound interest. The more often interest is compounded, the faster it grows.