Interest rates are crucial to many aspects of our financial lives, impacting borrowing costs, savings opportunities and the economy. Understanding how interest rates work empowers individuals to manage their finances and make informed decisions.
In general, interest rates are a measure of how much additional money you will pay for the privilege of using someone else’s asset (cash, consumer goods, property and even credit). Individuals can be charged interest on loans such as mortgages or auto loans; businesses can be paid it on assets such as equipment or inventory; or savers earn it on accounts such as savings and certificates of deposit. The amount of interest charged or earned is based on a variety of factors, including the borrower’s creditworthiness and the economic situation.
Low interest rates make it cheaper for consumers to purchase large assets, such as homes or cars. That spurs spending throughout the economy and creates a positive cycle of growth.
As interest rates rise, it becomes more expensive to purchase big assets, which in turn reduces spending and slows growth. However, higher rates are beneficial for savers as it provides a higher yield on their investments, such as savings or money market accounts.
Banks set their own interest rates, influenced by the Federal Reserve’s federal funds rate. The Fed can also lower or raise the federal funds rate to control the economy and encourage lending.
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