Whether you’re securing a loan, managing credit or saving money, interest rates play an important role in your financial picture. Understanding exactly how they work can reap financial dividends now and well into the future.
Generally speaking, an interest rate is the amount paid or earned on an investment based on a percentage of its principal. This is what you pay a lender when you borrow their money, or what you earn when you deposit your savings with a bank or credit union.
The types of loans you take out, how long you have to repay them, and other factors all impact your interest rate. So, too, do the different types of investments you make. Whether you’re comparing the costs of one mortgage against another, or determining how much to save each month to hit your retirement goal, understanding interest rates helps inform your financial decisions.
Interest rates can affect the economy in a variety of ways, from slowing down growth to boosting it. For example, when interest rates rise, consumers may reduce their spending because it will cost them more to buy things with the money they have. This is a key reason why the Federal Reserve often raises rates to cool down economic activity.
It’s also important to note the difference between nominal and real interest rates. Nominal interest rates, typically advertised for loans and savings accounts, ignore inflation and fees to provide a less-than-accurate depiction of a loan’s true costs or returns. The annual percentage yield (APY) on savings accounts and certificates of deposit takes inflation and fees into account, providing a more accurate picture of earnings or costs.
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