Interest rate is the amount of interest due per period, as a percentage of the principal sum lent or deposited. Typically, interest rates are annualized when used for consumer loans (credit cards, mortgages, etc). The three key variables that determine total interest owed are the principal sum, compounding frequency, and duration.
Interest rates factor into our everyday lives in many ways, from how much it costs to borrow money and pay back debt, to what kind of returns we’ll get on investment vehicles like savings accounts. Understanding how they work can help you make better financial decisions.
The market for money and credit is determined by supply and demand, and like the marketplace for goods and services, interest rates fluctuate based on these factors. When there’s greater demand for loan funds, lenders raise their interest rates to entice potential borrowers. Conversely, when demand is low, interest rates fall.
Some factors that influence interest rates include the risk of default, the opportunity cost of holding funds for longer periods of time, and the fact that shorter-term loans are less likely to default than long-term debt. Additionally, the type of debt or loan affects interest rates, with mortgage loans generally having lower rates than personal loans or credit card debt, as banks can foreclose on property if they don’t receive payments.
Individuals can also influence interest rates, by evaluating different lenders’ offers and shopping around. For example, some fees that are normally charged when purchasing a new home or car can be “bundled” into the interest rate and therefore reduced the amount of total interest owed.