What is an interest rate?
An interest rate is the rate charged for borrowing money.
Interest rates are typically expressed as an APR (Annual Percentage Rate). This is the yearly cost of borrowing or loaning money.
Calculator: How fast can your money grow?
Who sets interest rates?
In the US, they are determined by The Federal Reserve (the Fed) and The Federal Open Market Committee.
Interest rates change all the time and can vary depending on the type of loan.
Some of the factors that affect interest rates:
- Government Borrowing
- Supply and Demand of Money
When the economy is strong → interest rates are HIGH
When the economy is strong, more people want to invest and buy houses. Since there is a high demand for money, the Fed is more likely to raise rates.
When the economy is weak → interest rates are LOW
When the economy is weak, there is less demand for money. Therefore, the Fed is likely to lower rates to increase purchase.
How do interest rates work?
When you borrow money, the amount you receive is called the principal. And when you pay back the loan, you repay the principal plus interest. The interest amount is determined by the interest rate, (expressed as a percentage) and can have a significant effect on how much you have to pay back.
Borrowing money with interest costs more money, while loaning or investing money with interest earns more money. That’s why a high interest rate is good for lenders but bad for borrowers.
Interest rates are charged not only for loans, but also for:
- Credit cards
- Unpaid bills
- Student loans
- Auto loans
- And many other financial products
To calculate simple interest:
A = P(1 + rt)
- A = Total (Principal + Interest)
- P = Principal
- r = Rate of interest per year
- t = Time period in months or years
If you took out a student loan for $50,000 at an interest rate of 5%, and you wanted to pay it off in one year:
A = 50,000( 1 + (0.05 * 1)) = $52,500
So by taking out a loan you end up owing $2,500 more than you would without a loan.
Here is a calculator to test out the equation
How do I get a good rate?
The lowest interest rates are given to the highest-quality borrowers.
You can lower your rates by:
- Minimizing your debt
- Paying bills on time
- Maintaining a high credit score
Types of interest rates
“London Interbank Offered Rate,” the interest rate that banks charge each other for loans; it is used as the standard for bank rates all over the world.
The lowest rate charged to the highest credit investors.
Non-revolving credit rate
The interest charged to consumers for automobiles, education, and large purchases.
Revolving credit card rate
This is the interest rate a cardholder is charged for borrowing money to make payments, and it is usually one of the highest interest rates.
The importance of high and low interest rates
Low interest rates
Lower mortgage interest rates → Lower housing prices → More demand for real estate.
Less interest on deposits → More spending than saving → More money into high risk/high reward investments.
More affordable loans → Business growth → New jobs.
More cash in circulation → Higher prices → More dollars chasing the same number of goods and services → Inflation.
High interest rates
Higher interest rate on deposits → More people saving → Increased earnings.
Here are some countries that currently offer the highest deposit interest rates in the world.
More expensive to borrow money → Many purchases do not happen → Less demand for credit
Less money to grow businesses → Businesses slow down → Fewer jobs.
Less demand for goods → Fewer sales → Unemployment rises → Real estate prices fall → Recession.
International Interest Rates
If you deposited $1000 in a bank in Argentina, in one year, your balance would be $1245. In five years, it would grow to $2991. Unfortunately though, investors in these countries must consider the political instability risks, non-payment risks, and currency risks.
Inflation and interest