Interest rates are important to anyone who lends money or borrows it, and affect our everyday financial decisions, from mortgages and credit card debt to personal loans and investment accounts. Understanding how they work helps us make better borrowing, saving, and investing choices. Rate changes are driven by many factors, including the supply and demand for credit, inflation, and government monetary policy.
Interest is the fee that lenders charge (or pay) for the use of their money, expressed as a percentage of the principal amount borrowed or lent. It compensates the lender for the loss of opportunity to invest its funds in other ways, such as earning income or purchasing other assets. The higher the interest rate, the more expensive it is to borrow.
A key factor in determining interest rates is the economy’s strength or weakness. Low interest rates make it cheaper to borrow money, stimulating economic activity. But in the long run, they can lead to market disequilibrium where demand for credit outpaces supply, causing inflation. Consequently, governments may raise interest rates to slow the economy and combat inflation.
Another key factor in determining interest rates is the type of loan or debt being used. For example, a longer loan or debt can carry a higher interest rate because there is more time for the borrower to default on the loan. A third factor is risk. Lenders may require a higher rate when they think there is a greater chance that they won’t be repaid, or if the loan is being used to purchase high-risk investments such as stocks.