Interest rate

Definition

An interest rate is the percentage at which interest is charged or paid for the use of money, typically expressed as an annual percentage. This rate affects how much money you can earn from savings or how much extra you have to pay on borrowed funds. Understanding interest rates is crucial because they influence loan affordability, savings growth, and overall financial planning.

5 Must Know Facts For Your Next Test

1. Interest rates can be fixed, meaning they stay the same throughout the loan term, or variable, meaning they can change based on market conditions.
2. In savings accounts, higher interest rates can significantly increase the amount of money earned over time due to compound interest.
3. Central banks, like the Federal Reserve, set benchmark interest rates that influence lending rates throughout the economy.
4. Interest rates play a key role in personal finance decisions, affecting choices related to credit cards, mortgages, and savings accounts.
5. The relationship between supply and demand for credit influences interest rates; when demand is high, rates tend to rise.

Review Questions

• How do interest rates impact both saving and borrowing decisions in personal finance?
  • Interest rates significantly influence personal finance by determining how much you earn from savings accounts and how much you pay on loans. When interest rates are high, saving becomes more attractive because your money grows faster. Conversely, borrowing costs increase as well, making loans more expensive. Therefore, individuals often adjust their saving and borrowing habits based on current interest rates to optimize their financial situation.
• Compare and contrast fixed and variable interest rates in terms of their implications for borrowers.
  • Fixed interest rates remain constant throughout the life of a loan, offering borrowers predictable monthly payments and protection against future rate increases. On the other hand, variable interest rates can fluctuate based on market conditions, which may lead to lower initial payments but also potential increases in future payments. Borrowers must weigh these options carefully; fixed rates provide stability while variable rates might offer short-term savings but come with uncertainty.
• Evaluate how changes in central bank policies regarding interest rates can affect economic activity on a broader scale.
  • Changes in central bank policies regarding interest rates can have profound effects on overall economic activity. When a central bank raises interest rates, borrowing becomes more expensive, which can slow down consumer spending and business investments, potentially leading to an economic slowdown. Conversely, lowering interest rates tends to encourage borrowing and spending, stimulating economic growth. Therefore, central banks strategically adjust interest rates to manage inflation and promote economic stability.

Related terms

Principal:

The original sum of money borrowed or invested, excluding any interest or fees.

APR (Annual Percentage Rate): A broader measure of the cost of borrowing that includes the interest rate plus any additional fees or costs associated with the loan.

Rate of Return: The gain or loss made on an investment relative to the amount of money invested, expressed as a percentage.