Interest rates play a critical role in our financial lives and understanding how they work is essential to making smart financial decisions. They’re involved in almost all formal lending and borrowing transactions and can be seen in the charges on a credit card bill, the growth of a savings account or Certificate of Deposit (CD) account, the cost of a mortgage loan, the amortization of long-term assets and more.
An interest rate is the price that borrowers pay to lenders for the use of their funds, expressed as a percentage of the principal amount of the original transaction. Lenders also receive interest from savers, which is reflected in the annual percentage yield of a savings or investment account.
The specifics of how a rate is calculated can vary by lender and type of debt. For example, mortgage loans often have lower rates than credit card and personal loan debts because they are secured by real estate or other collateral. The amount of time the loan or debt lasts can also impact rates, with longer loan terms requiring higher rates than shorter term debts.
Another factor in determining interest rates is whether the interest is simple or compounded. Simple interest is applied only to the principal, while compounding applies the rate to both the principal and previous accrued interest. Inflation and other bank fees can also affect the actual interest that is applied, a distinction sometimes made between nominal and real interest rates.