# Interest rate

Interest rates are the cost of borrowing money, expressed as a percentage of the principal amount, charged by lenders to borrowers for the use of their funds.
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Updated: Jun 4, 2024

## 3 key takeaways

• Interest rates represent the cost of borrowing or the return on investment for lending money, influencing economic activity and financial decisions.
• Central banks set benchmark interest rates to guide monetary policy, impacting inflation, employment, and overall economic growth.
• Different types of interest rates include fixed, variable, and compound rates, each affecting the total cost of borrowing and investment returns.

## What are interest rates?

Interest rates are the percentage charged by lenders to borrowers for the use of their money over a specified period. They are fundamental to the functioning of financial markets and economies, influencing borrowing, lending, and investment decisions.

## How interest rates work

Interest rates can be categorized into several types based on how they are applied and calculated:

• Fixed Interest Rate: The interest rate remains constant throughout the loan or investment period. This provides predictability in repayment amounts.
• Variable Interest Rate: The interest rate can change over time, typically based on an underlying benchmark rate like the LIBOR or the federal funds rate. This can lead to fluctuating repayment amounts.
• Compound Interest Rate: Interest is calculated on both the initial principal and the accumulated interest from previous periods. This results in exponential growth of the amount owed or invested.

### Example of interest rate calculation

Suppose a person takes out a \$1,000 loan with a fixed annual interest rate of 5% for one year.

Interest=Principal×Interest RateInterest=Principal×Interest Rate

Interest = \$1,000 × 0.05 = \$50

The total amount to be repaid at the end of the year would be \$1,050.

## Factors influencing interest rates

Several factors determine the levels of interest rates in the economy:

• Central Bank Policies: Central banks, such as the Federal Reserve, set benchmark rates to influence economic activity. Lower rates typically encourage borrowing and spending, while higher rates aim to curb inflation.
• Inflation: Higher inflation often leads to higher interest rates as lenders demand compensation for the decreasing purchasing power of money over time.
• Economic Conditions: Economic growth, employment rates, and market stability impact interest rate levels. Strong economic conditions can lead to higher rates, while weak conditions may prompt rate cuts.
• Credit Risk: Borrowers with higher credit risk are usually charged higher interest rates to compensate lenders for the increased risk of default.

## Importance of interest rates

Interest rates play a critical role in the economy for several reasons:

• Cost of Borrowing: They determine how expensive it is to borrow money, affecting consumer loans, mortgages, and business financing.
• Savings and Investment: Interest rates influence the returns on savings and investments, guiding individuals and businesses in their financial planning.
• Monetary Policy: Central banks use interest rates to control inflation, manage economic growth, and stabilize the financial system.

## Example of interest rate impact on loans

Consider a homebuyer taking a mortgage loan of \$200,000 with an annual interest rate of 4% for 30 years. The monthly payment can be calculated using a mortgage formula, which takes into account the principal, interest rate, and loan term.

### Example Calculation

Using a mortgage calculator, the monthly payment for this loan would be approximately \$955.

If the interest rate were to rise to 5%, the monthly payment would increase to about \$1,073, illustrating how interest rates directly impact borrowing costs.

## Types of interest rates

Different financial products and economic activities involve various types of interest rates:

• Mortgage Rates: Applied to home loans, typically offered as fixed or adjustable rates.
• Credit Card Rates: Often variable rates tied to a benchmark, with higher rates reflecting the unsecured nature of the debt.
• Savings Account Rates: The return paid by banks on deposits, influenced by central bank rates and market conditions.
• Bond Yields: The interest rate paid by issuers of bonds, reflecting the creditworthiness of the issuer and market interest rates.

Interest rates are a fundamental component of the financial system, affecting borrowing, lending, and investment decisions across the economy. By understanding the various types of interest rates and the factors that influence them, individuals and businesses can make informed financial choices and manage their economic activities effectively.

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AI Financial Assistant
Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000... read more.