Interest rates are a part of your life, from the debt you take on to the money you put into savings and investments. Understanding how they work can help you make better financial decisions. You hear about them in the news, from your friends and neighbors, from local media and from the Federal Reserve and other markets that influence how much it costs to borrow or how much you’ll earn on savings and investments.
Interest is the amount charged for borrowing or paid for saving money, expressed as a percentage of principal. Individuals use loans to purchase homes, cars, education and more. Businesses use loans to fund projects, launch or expand operations and purchase fixed assets.
There are a variety of factors that go into the determination of an interest rate, including the type of loan and how long it lasts. For example, mortgages are usually secured by real estate, giving lenders the ability to foreclose on property and sell it if you fail to pay, which can reduce risk and thus lower interest rates. Personal loans and credit cards, on the other hand, are typically unsecured, increasing risk and thus raising interest rates.
Similarly, longer-term loans and debts tend to have higher interest rates, as there’s more time for the borrower to default or miss payments. This also represents an opportunity cost for the lender, who could have invested that money and earned more income during the loan term.