Interest rate is a measure of the cost of money owed on loans and the growth potential of savings accounts. Whether you’re shopping for loans or investing money, understanding how interest works can help you save more on debt and maximize the returns of your savings. Different factors affect how much you pay or earn in interest, such as compounding frequency and loan terms. Keeping tabs on the economy and personal factors like your creditworthiness can also change your rates.
The purpose of interest rates is to promote lending, spending and investment to maintain the economic system. Central banks modify these rates to accomplish macroeconomic goals, including price stability, full employment and sustained economic growth.
When you borrow, you owe the lender a portion of the main value of the funds borrowed. The lender charges interest to offset the opportunity cost (lost potential earnings if the lender invested the funds elsewhere) and the risk that you may not return the loan in full. This arrangement is a win-win for both parties: the lender receives interest payments to offset the risk, and the debtor pays a small fee to obtain funds quickly.
The amount you pay or earn in interest depends on your lender and the market. Banks typically use a formula to calculate their interest rates, which includes your creditworthiness, collateral and other factors. Your creditworthiness is largely determined by your FICO credit score, which lenders use to determine the likelihood that you’ll repay your debt. A market rate, such as the Wall Street Journal prime rate, also influences your loan rates.