Whether you’re borrowing money, saving for retirement, or making investments, interest rates play an important role in your day-to-day finances. Understanding the role of interest rates can help you make informed financial decisions and better manage your money.
Interest rates are the price you pay for accessing money you don’t have or the reward you earn for letting someone else use yours. They reflect the “time value of money” — meaning that funds available today are worth more than those available tomorrow due to inflation and opportunity costs (potential earnings you lose by not investing your money elsewhere).
You’ll see interest rate references in many formal lending and savings transactions, such as mortgage rates, credit card charges, loan repayment periods, amortization of long-term assets, the growth of retirement accounts, and even the discount a supplier might offer for paying off an invoice early. While you may not be able to control or predict these interest rates, there are some things you can do to minimize them.
For example, you can borrow at opportune times when economic factors are favorable. You can also shop around for lenders and negotiate with them. And, of course, you can reduce your interest rates by increasing your down payments.
In addition to the time value of money, other factors that affect interest rates include the risk that you might not be repaid and the cost of insurance against this risk. This factor is often called the financial risk premium. Depending on the lender, the premium may be less or more than the actual interest rate you are being charged.