An interest rate is the cost of debt for the borrower and a rate of return for the lender. It is calculated as a percentage of the principal sum and applied over a period, which is usually a year but may be less than a year. This percentage is also often referred to as the annual percentage rate (APR). It’s important to understand interest rates because they play a major role in financial decision making. Whether you’re looking to secure a loan, manage your credit or build savings, understanding the concept of interest can save you thousands or even tens of thousands of dollars over time.
Interest rates are influenced by a variety of factors. The most obvious is the risk profile of a particular type of debt. For example, mortgages are secured by real estate which reduces the risk of default. That’s why they generally have lower interest rates than personal loans or credit cards, which aren’t secured by anything other than a person’s promise to pay.
Other factors include the economy, which influences the demand for money and credit. When there is a lot of demand, lenders raise interest rates to encourage borrowing. When the economy slows, the opposite happens and interest rates decline.
In addition, the compounding frequency and length of the debt or savings period can impact total interest. It is important to know how these factors affect your interest rate, which can help you compare different options when shopping and negotiating for loans or savings.