Interest rates are important to understand because they shape the financial landscape by influencing the cost of borrowing money and the return on investments. Interest rates play an integral role in personal finance decisions such as choosing the right credit card and mortgage and long-term investment strategies like retirement savings. Interest rates are vital to business financing and asset valuations as well.
The concept behind interest is quite simple: For a loan or investment, the initial sum of money received is multiplied by the rate of interest and then added to the principal to form a total amount owed or earned. The rate of interest is usually applied over a set period of time known as the term of the loan or investment.
There are many factors that influence interest rates. For example, lenders may look at your credit score and other data to determine your creditworthiness before deciding what interest rate to charge you for a debt or investment. The type of asset, length of the loan and the risk factor will also impact the interest rate.
Similarly, the federal funds rate has an effect on the interest rates for certain types of savings products such as money market accounts and CDs. Inflation is another important factor that can impact interest rates. When inflation is high, it can lead to higher interest rates as borrowers and savers seek higher returns on their assets. Conversely, when interest rates are low, borrowers may spend more and businesses may invest in riskier investment vehicles to make up for lower potential return on savings.