Interest rates play a critical role in your financial life, from how much it costs to borrow to how much you can earn on savings. But they can also be confusing, especially when it comes to figuring out what exactly goes into your credit card or mortgage interest rate, and how the market influences the state of your savings.
The most common function of an interest rate is the cost of borrowing or the reward for saving. It is a percentage of the borrowed amount and is often quoted as an annual percentage rate (APR) on loans. However, a more accurate way to express interest is through compounded annual percentage yield, which takes the effect of compounding into account.
High interest rates can make it more expensive to borrow money, which can slow consumer spending and economic growth. On the other hand, low interest rates can encourage consumers and businesses to spend more by making it cheaper to finance expansion projects.
Other factors that can influence interest rates include liquidity preferences, the availability of tax breaks and the risk premium. For example, if lenders think there is a high risk that they will not be repaid, they may add a risk premium to the interest rate. Conversely, if they are confident that their loan will be paid back in full, they may charge a lower interest rate. All of these factors are influenced by macroeconomic conditions such as inflation, monetary policy and GDP.