Interest rates play important roles in your finances, as they determine how much it costs to borrow money and how much you can earn on investments. It’s essential to understand how interest rates work and how they can be affected by changes in the economy.
The rate of interest is the price that lenders charge for lending their money to borrowers or the amount earned from deposit accounts, such as savings accounts and certificates of deposits (CDs). Typically, it’s quoted on an annual basis, expressed as a percentage of principal. The interest rate on loans is referred to as an annual percentage rate (APR), while the interest rate on savings and investment accounts is usually noted as an annual percentage yield (APY).
In a free market, the interest rate is determined by supply and demand. The supply of funds is influenced by the willingness of consumers, businesses, and governments to save, while the demand for funds reflects the desire of individuals to invest in businesses and houses. During strong economic conditions, the desire to invest in businesses and housing tends to drive interest rates up.
The interest rate also takes into account the opportunity cost of holding funds. The longer the loan or debt, the greater the opportunity cost, as the money that’s lent out is not being invested in anything else. That’s why interest rates on long-term loans and debt tend to be higher than for shorter terms.