Interest rates have a big impact on your finances. They determine how much it costs to take out a loan or invest in securities, and they can save or cost you thousands — or even tens of thousands — of dollars over the life of a major loan such as a mortgage. Understanding the mechanics of how interest rates work is key to managing your debt, saving for retirement or other financial goals and making sound investment decisions.
The simple definition of an interest rate is the compensation a lender receives for agreeing to postpone use of its wealth. It is measured as a percentage of the amount of wealth whose consumption is postponed. Think of it as Aunt Carmen offering you $1,000 if you agree to wait a year for her payment. The rate of interest fluctuates based on supply and demand, the rate of inflation and government monetary policy. The interest rate for different types of loans also differs based on credit risk, timing and tax considerations.
High interest rates make it more expensive to borrow money, and that can slow economic activity. Conversely, low interest rates can stimulate lending and investment and lead to higher economic growth. Interest rates are influenced by many factors, including supply and demand for credit, the cost of borrowing, the rate of inflation and monetary policy set by the Federal Reserve. Understanding these factors can help you decide whether to opt for a variable or fixed interest rate when borrowing money.