Interest rates play a key role in how much your debt costs and how much you earn on investments. Understanding how they work can help you make smarter financial decisions and manage your finances better.
In simplest terms, interest is the charge that is added to the principal amount of money borrowed or invested in a savings vehicle, such as a credit card account balance, mortgage, personal loan, certificate of deposit (CD) or bank savings account. It’s a way for lenders and creditors to compensate themselves for the risk of lending or investing their money.
Lenders and creditors may use a variety of factors to determine the interest rate they offer, including an individual’s creditworthiness. To assess that, they look at FICO credit scores, credit reports and other data from a person’s past financial transactions. Interest rates are also affected by economic trends, such as the Federal Reserve’s target rate for borrowing and investment.
High interest rates can hurt borrowers by increasing the cost of mortgages, credit cards and student loans. They can also slow the economy and lead to price inflation. In addition, they can create inefficiencies when unprofitable businesses that can’t sustain themselves hang on thanks to infusions of free cash.
On the other hand, rising rates can signal a healthy economy and encourage savings. They also boost the return on deposits in savings accounts and CDs and can increase entitlement payments like Social Security. Manufacturers of kitchen appliances, clothing retailers and companies that sell heating, ventilation and air conditioning systems tend to perform well during interest rate increases.