What is Interest Rate?

Interest rate is the amount charged by lenders to borrowers for the use of money, expressed as a percentage of the principal, or original amount borrowed; it can also be described as the cost to borrow money. For instance, an 8% interest rate for borrowing $100 a year will obligate a person to pay $108 at year-end.

Generally, borrowers want the lowest possible interest rates because it costs less to borrow; conversely, lenders or investors seek high interest rates for larger profits. Interest rates are usually expressed annually, but rates can also be expressed as monthly, daily, or any other period.

Simple vs. Compound Interest

There are two methods for calculating interest. Simple interest is calculated as a percentage of principal only, while compound interest is calculated as a percentage of the principal along with any accrued interest. Compounding increases interest over time.

Fixed vs. Variable Interest Rates

Fixed rates stay constant for the life of the loan, while variable rates fluctuate over time based on market conditions, inflation, or reference rates.

APR (Annual Percentage Rate)

The APR represents the annual cost of borrowing including certain fees, while the APY reflects interest earned in savings or deposits.

Uncontrollable Economic Factors

Economic Policy and Inflation

Interest rates fluctuate due to central bank policies controlling inflation. Lower interest rates stimulate borrowing and spending, while higher rates slow down economic activity.

Economic Activity

Interest rates impact business expansion, job creation, and consumer confidence. Central banks adjust rates to balance growth and inflation.

Unemployment Rate

High unemployment generally lowers interest rates to encourage spending, while low unemployment may push rates up to control inflation.

Supply and Demand

The credit market is influenced by supply and demand. Higher demand for money leads to higher rates, and lower demand results in lower rates.

Controllable Factors

Credit Standing

A borrower's credit score directly affects the interest rate offered. Higher scores receive better rates.

How to Receive Better Rates

• Opt for secured loans when possible.
• Make higher down payments or choose shorter loan terms.
• Limit credit inquiries.
• Borrow when economic conditions are favorable.
• Research multiple lenders to negotiate better rates.

Real Interest Rate

The relationship between real interest rate, inflation, and nominal rate is: