Interest rates play critical roles in your personal and business finances, determining both the cost of borrowing money and the return you earn on savings. Understanding how they work can help you make smart financial decisions.
An interest rate is the amount of compensation a lender charges a borrower for the use of its funds, calculated as a percentage of the borrowed principal. This is the primary method by which lenders earn income from loans, credit cards, mortgages, etc. During periods of low interest rates, individuals can often obtain loans at relatively inexpensive rates, which stimulates spending and helps the economy grow. However, this may eventually cause market disequilibrium that leads to inflation – a concept known as Walras’ law.
When interest rates rise, it usually costs more to borrow money, and can affect the profitability of certain types of investments, such as real estate and bonds. But higher rates can also improve the performance of savings accounts and certificate of deposit (CD) rates, as banks can offer more competitive rates to attract deposits and offset their lending costs.
The Federal Reserve adjusts interest rates to steer economic growth and manage inflation. The Fed’s goal is to keep long-term interest rates stable, which helps reduce the risk of rising prices and keeps more money in the hands of consumers and businesses.