Interest rates play a crucial role in the economy, impacting everything from mortgages and credit cards to savings accounts and retirement funds. However, interest rates can often seem complex and confusing, especially for those with limited financial knowledge.
This comprehensive guide serves as an introduction to interest rates tailored for total beginners. It explains what interest rates are, how they are calculated, different types of rates, what factors influence them, and their overall role in the economy. Whether you’re looking to better understand the interest charged on your loans or earned on your savings, this 7,000+ word guide will help demystify interest rates.
Below is an overview of what this guide covers:
- What Are Interest Rates?
- Why Do Interest Rates Matter?
- How Interest Rates Work
- Types of Interest Rates
- What Influences Interest Rates?
- Interest Rates in the Economy
- Calculating Interest Rates on Loans
- Calculating Interest Rates on Savings
- The Rule of 72 for Interest Rates
- Key Terms About Interest Rates
- Frequently Asked Questions
By the end, you’ll have a solid understanding of what interest rates are, how they impact consumers and the broader economy, and how they are determined. Let’s start with the basics.
What Are Interest Rates?
An interest rate is the percentage charged on borrowed money or earned on savings. It is expressed as an annual percentage rate (APR).
When you take out a loan, like a mortgage, car loan, or business loan, the lender charges interest on top of the borrowed principal amount.
Likewise, when you save or invest money in vehicles like savings accounts, certificates of deposit (CDs), or bonds, you earn interest on top of your original principal.
Higher interest rates benefit savers, as they earn more interest income. However, higher rates disadvantage borrowers, as they must pay more interest on top of loan principal.
Interest serves as compensation for both parties. Savers forego using their money now to earn interest in the future. Lenders provide money upfront to borrowers but earn interest in return.
This back and forth between interest rates and markets drives the flow of money in the economy. Even small rate changes ripple across consumers and businesses.
Why Do Interest Rates Matter?
Interest rates hold massive importance for consumers, businesses, investors, and the economy as a whole for several key reasons:
- Rates influence the cost of loans for cars, houses, education, and more
- Rates impact how much interest savings and CDs earn
- Rates determine the cost of borrowing for investment and operations
- Rates affect consumer demand and spending capacity
- Rates drive bond prices and yields in opposite directions
- Rates impact stock and asset valuations across markets
For the Economy
- Rates influence economic growth and inflation
- Rates are the main lever for central banks to impact monetary policy
Given this enormous scope of impact, understanding interest rates helps consumers make better financial decisions and evaluate how broader economic conditions may affect their financial lives.
Now that you know why interest rates matter so much, let’s explore the fundamentals of how they actually work.
How Interest Rates Work
Interest rates operate around a simple core concept – the time value of money.
A dollar today is worth more than a dollar in the future thanks to its immediate earning potential. This drives two parties – borrowers and lenders – to exchange present and future use of money.
Borrowers pay interest for the right to spend money now rather than later. Lenders earn interest by providing money to borrowers now with repayment in the future.
This give-and-take centers around quantifying the “price” of exchanging present and future access to money – the interest rate.
Key Forces Impacting Interest Rates
Several key forces interact to influence interest rates available to borrowers and lenders:
- Inflation – Higher inflation typically lifts interest rates, as the future money becomes less valuable.
- Default Risk – Lenders demand greater interest from riskier borrowers who may not repay loans.
- Central Bank Rates – Government central banks directly impact rates through monetary policy.
- Economic Forces – Factors like GDP growth and unemployment affect rates through supply and demand.
The complex interplay of these forces results in frequently changing interest rates that reflect the cost of borrowing and lending money at any given time.
Rates vary not only over time, but for different types of borrowers, lenders, loan terms, and savings vehicles. Let’s examine these different categories next.
Types of Interest Rates
Many different types of interest rates exist in finance. Here are the most common categories and examples consumers will encounter:
Personal Loan and Credit Interest Rates
- Credit cards – 15-25% APR typically
- Mortgages – 4-7% for prime borrowers, rates vary by down payment, credit score, loan type, and term
- Auto loans – 4-20% depending on credit score and new/used vehicle
- Personal loans – 6-36% depending on credit score and lender
- Student loans – 3-12% from federal and private lenders
Business Loan Interest Rates
- Small business loans – 7-12%+ depending on business credit/collateral
- Commercial real estate loans – Varies, average multifamily and retail around 4-5%
- Equipment financing – 5-20% based on credit and asset financed
- Business lines of credit – Varies by prime rate, credit score, and collateral
Interest Rates for Savers
- Savings accounts – 0.5-1% annual percentage yield currently
- Money market accounts – 0.5-2% APY based on account minimums
- CDs – 0.5-3% APY based on term length (3 months to 5+ years)
- High yield savings – 1-2% APY frequently, some offer promotional rates
- Bonds – Varies, government bonds ~3%, corporate bonds 4-7%
Benchmark Interest Rates
- Prime rate – Benchmark rate on corporate loans, currently 3.5%
- Federal Funds rate – Rate banks pay to borrow from Federal Reserve, currently 1.5-1.75%
- 10-year Treasury yield – Return on 10-year US government bonds, currently around 3.5%
Those are some of the most common categories of interest rates. However, within each category, consumers will see a range of rates based on specific factors like credit score, loan amount, asset purchased, collateral provided, and lender policies.
Now that you understand the types of rates, let’s examine what influences them.
What Influences Interest Rates?
Many factors determine the interest rates borrowers pay and savers can earn at any given time. However, government central banks play an especially large role in rate setting.
Central Bank Policy
In the United States, the Federal Reserve sets the target range for the federal funds rate. This is the rate banks pay to borrow and lend money to each other overnight.
The Federal Open Market Committee (FOMC) meets about eight times per year to discuss economic conditions and vote whether to move their target interest rate range up or down.
When the Fed raises its target rate range, interest rates available to consumers and businesses subsequently rise as well. Conversely, rate cuts by the Fed pull other interest rates lower in the broader economy.
The Fed primarily adjusts rates based on economic growth and inflation. More on that momentarily.
Creditworthiness of Borrowers
For individual consumer and business loans, the applicant’s creditworthiness significantly impacts the interest rate offered by lenders.
Lenders quantify creditworthiness using credit reports and FICO or business credit scores generated from applicant history repaying debts.
Higher scores signal lower default risk. As a result, borrowers with excellent credit qualify for the lowest interest rates on loans and credit cards, while applicants with poor credit pay higher rates.
Term of the Loan or Deposit
In general, shorter-term loans and deposits carry lower interest rates than longer-term ones.
For example, mortgage rates on 15-year loans are lower than 30-year mortgages. Money market accounts offer lower rates than 5-year CDs.
Longer obligations tie up lender capital for extended periods, increasing risk and requiring greater compensation via higher interest rates.
Factors like economic growth, employment levels, and inflation all impact interest rates:
GDP Growth – Accelerating growth typically lifts rates, as businesses invest and borrow more. Slowing growth leads to lower rates.
Unemployment – Low unemployment spurs higher rates reflecting greater loan demand. High unemployment lightens demand and encourages rate cuts.
Inflation – Rising inflation diminishes purchasing power of future dollars, so lenders demand higher rates as compensation.
These factors influence central bank rate decisions, which then filter down to consumer lending and savings rates across the economy.
Okay, now that you know what impacts rates, let’s see how to actually calculate interest costs on loans.
Calculating Interest Rates on Loans
The formula to determine the total interest owed on a loan is:
Interest = Principal x (Interest Rate/100) x Term in Years
This calculates the annual interest amount. You then divide by 12 months to determine the monthly interest payment on a loan.
For example, for a $300,000 mortgage at 6% interest over 30 years:
Annual Interest = $300,000 x (6/100) x 30 = $180,000
Monthly Interest = $180,000 / 12 Months = $15,000
So the annual interest works out to $180,000, or $15,000 per month.
This example has simple interest. Some loans like mortgages involve compound interest, meaning interest accrues on unpaid interest from prior periods. This results in higher total interest costs over time.
Now let’s look at calculating interest earned on savings vehicles.
Calculating Interest Rates on Savings
Savers want to maximize interest income on their deposits and investments. The formula to calculate annual interest on savings is:
Annual Interest = Principal x (Interest Rate/100)
For example, on a savings account with a $10,000 balance earning 1% APY interest per year:
Annual Interest = $10,000 x (1/100) = $100
Pretty straightforward! For accounts with monthly compounding, divide the above annual interest by 12 to get the amount added each month.
You can validate interest calculations by reviewing statements from your financial institution. Many also provide interest rate calculators on their websites for prospective customers.
The Rule of 72 for Interest Rates
Here’s a handy mental shortcut to estimate how long it will take money to double based on a given interest rate. It’s called The Rule of 72.
Simply divide 72 by the interest rate, and the result is the approximate number of years for a lump sum to double.
For example, if someone inherits $50,000 and invests it at a 6% interest rate, how long until it doubles?
Per the Rule of 72: 72 / 6 = 12 years
Therefore, it would take approximately 12 years for the $50,000 to become $100,000 at a 6% annual rate.
This demonstrates the power of compound growth! Use the Rule of 72 to set savings goals or estimate loan payoff timeframes.
Key Terms About Interest Rates
Here are some other key terms to know related to interest rates:
- APR – Annual percentage rate on loans or savings accounts with interest
- Compound Interest – Interest calculated on initial principal plus accumulated interest
- Fixed vs Variable Rates – Fixed stay the same, variable rates fluctuate
- Nominal vs Real – Nominal doesn’t account for inflation, real does
- Simple Interest – Interest calculated on initial principal only
- Annual Percentage Yield (APY) – Rate including compounding effects over one year
Now let’s tie together everything you’ve learned by looking at some frequently asked questions.
Understanding interest rates helps you make better financial decisions and chart your financial future more strategically. This guide provided a broad overview of what interest rates are, how they work, and the many factors that influence them.
While rates can seem complex on the surface, having a grasp of the basics goes a long way. Be sure to stay up to date on rate changes and keep their impact in mind as you consider loans, savings accounts, and investments over your lifetime.
Frequently Asked Questions About Interest Rates
How are interest rates determined?
The Federal Reserve sets its target federal funds rate based on economic conditions, which then filters to rates from consumer and business lenders. Banks also set rates on loans and savings accounts based on this target, default risk, competitive factors, and profit goals.
What is a good interest rate?
Whether an interest rate is good or not depends if you are the borrower or the saver. For savings, you want the highest yield possible. For borrowing, the lowest reasonable rate is ideal. Aim for rates under 5% for major loans, and over 1% for savings deposits in the current environment.
Should I get a fixed or adjustable-rate mortgage?
Fixed-rate mortgages hold your interest rate constant for the full loan term, while adjustable-rate mortgages periodically move up and down. Choose a fixed rate if you want payment stability or expect rates to rise. Choose an ARM if you want lower short term payments and can manage uncertainty.
What happens when interest rates increase?
When interest rates increase, it gets more expensive for consumers and businesses to borrow money. Savings and CD rates may increase to attract deposits. Economic activity generally slows. Stock prices often decline due to uncertainty and money moving into bonds.
How often do interest rates change?
The Federal Reserve meets 8 times per year to review economic conditions and decide whether to adjust their target rate. Based on these changes, banks and lenders then periodically adjust the interest rates on consumer/business loans and deposit accounts as competitive factors warrant.
What is the current interest rate?
The Fed’s target rate is currently 1.5-1.75%. The prime rate is 3.5%. Rates on loans and savings vary by individual factors but follow the broader rate environment. Current mortgage rates are approximately 4-6% for prime borrowers.