The Meaning of Interest Rate

The interest rate

Each day on the television and in the media, you’ll see headlines on how interest rates are going. It’s a big talk about a really low, easy matter. The interest rate is how much money someone pays to borrow money. The reason so much is that this basic principle has many applications in the fields of industry, finance, and government.

Interest Rate Definition

The interest rate is the amount a lender charges for the use of assets expressed as a percentage of the principal. The interest rate is typically noted on an annual basis known as the annual percentage rate (APR). The assets borrowed could include cash, consumer goods, or large assets such as a vehicle or building.

Interest is the cost of borrowing money. An interest rate determines exactly what that cost is. For example, if Mark lends $100 to John at 8 percent interest, John has to pay back $108. That’s the easy part.

Then there’s compound interest, which has to do with larger sums borrowed over longer time periods. A car loan is a good example. Mark takes out an auto loan of $15,000 over a four-year period with an annual interest rate of 5%, and he makes monthly payments. He’ll pay $345.44 per month, which includes-over the course of four years–$1,581.12 in interest. That’s his cost of borrowing the $15,000.

How Interest Rates Work?

The bank applies the interest rate to the total unpaid portion of your loan or credit card balance, and you must pay at least the interest in each compounding period. If not, your outstanding debt will increase even though you are making payments.

Although interest rates are very competitive, they aren’t the same. A bank will charge higher interest rates if it thinks there’s a lower chance the debt will get repaid. For that reason, banks will tend to assign a higher interest rate to revolving loans such as credit cards, as these types of loans are more expensive to manage. Banks also charge higher rates to people they consider risky; The higher your credit score, the lower the interest rate you will have to pay.

The Federal Reserve

In the US, the Federal Reserve Bank loans money to corporate and mortgage banks. The Federal Reserve shall decide the interest rate that banks pay for their cash. This is known as the annual Prime rate (APR). Banks then turn around to lend to companies and individuals, typically charging a little more than the interest rate set by the Federal Reserve.

Savings & Certificates of Deposit

The cost of borrowing money will work in both directions. Once people deposit their money into savings accounts or deposit certificates, the bank directly borrows money from them. That’s why these accounts are getting attention. Currently, banks pay similar to the APR set by the Federal Reserve. We never pay more than their borrowing costs from the Federal Reserve. Even, though, consumers are expected to shop around. Many banks are seeking to attract new customers by charging higher interest rates on their accounts.

Economic Indicator

Interest rates are frequently addressed in the news as a measure of the performance of the economy. For a general rule, as the Federal Reserve reduces interest rates, it wants to make sure that cash flows into a weak economy. The theory is that the more money companies and customers move, the more the economy will work, which in turn will stimulate recovery.

Nevertheless, in stable economies, where cash flows go off on their own, the Federal Reserve usually sets a higher interest rate. Many people see the interest rate as an indicator of how the economy is going.

Loans, Mortgages and Credit Cards

Businesses and customers are more likely to experience the effect of interest rates on their loans. Commercial loans are a common way for small companies to obtain start-up capital and also fund transition, development, and enhancement. For customers, mortgages, car loans, and credit cards are common forms of borrowing. Interest rates matter as they decide monthly payments and whether a company or a person can afford to borrow money or not.

Traditionally, as interest rates dropped, consumers refinanced their homes to lower mortgage interest rates – making their home payments more manageable. In a tight credit market, refinancing can be more difficult, but there is a possibility to try credit adjustments in order to keep up with payments.

Bottom Line

  • Interest rates have an impact on how you spend your money. Bank loans are more expensive when interest rates are high. Borrowers and businesses are borrowing less and saving more. Demand falls, and businesses sell fewer items. The economy is shrinking. If it goes too far, it may cause a recession.
  • When interest rates fall, the opposite happens. People and companies borrow more, save less, and boost economic growth. But as good as this sounds, low interest rates can create inflation. Too much money chases too few goods.
  • The Federal Reserve manages inflation and recession by controlling interest rates. So pay attention to the Fed’s announcements on falling or rising interest rates. You can reduce your risks when making financial decisions such as taking out a loan, choosing credit cards, and investing in stocks or bonds.

See Also
What is Internal Rate of Return
What type of bank account has a high interest rate?