A combination of factors shapes interest rates, which affect the broader economy by impacting consumer spending and business investment. Understanding these influences and how to calculate interest rates can help you make smarter financial decisions.
An interest rate is a fee charged or earned on money that has been borrowed or invested. It is typically noted on an annual basis and expressed as a percentage of the amount borrowed or invested. Interest rates can be applied to loans, savings accounts, certificates of deposit (CDs), or investments, such as stocks or bonds.
Individuals borrow money to purchase homes, fund education or launch or grow their businesses. These borrowing transactions often involve an agreement to pay back the borrowed funds in a set amount at a predetermined future date, known as an amortization schedule. Interest rates are an important part of the agreement, as higher interest rates make the cost of borrowing more expensive.
There are several types of interest, including simple and compound interest. The latter is the most common form of interest, and is calculated by multiplying the principal amount by the current interest rate per period. For example, Jane takes out a $200,000 loan and agrees to pay 4% interest for the term of the loan. This means she will pay back the initial loan amount ($200,000) plus 4% interest over the term of the loan, which will result in the final repayment of $210,000.
There is also a real interest rate, which takes into account inflation. This formula is based on the Fisher equation and calculates the actual interest accumulated over time by comparing the original amount lent or deposited against the buying power of the principal at the beginning of the loan period.
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