Interest is an important factor in saving and growing wealth, as well as a significant component of borrowing money. The rate of interest affects your ability to save or spend and can significantly impact the amount you owe on loans, including credit cards, auto loans and mortgages. Understanding how interest works can help you make better financial decisions and plan for the future.
Interest can be calculated in a few different ways, but the most common is simple interest, which calculates a flat fee every year on the initial amount borrowed or paid. A more advanced formula is compound interest, which calculates the total accrued value on an ongoing basis and takes into account both previous payments as well as future payments.
A key aspect of interest is that it is a market-driven value, meaning that it is determined by supply and demand for credit or money. When there is high demand, lenders raise rates to entice borrowers, and vice versa.
Individuals can also influence their interest rates to some extent, based on their creditworthiness and the types of savings or investment accounts they have. However, large macroeconomic factors, such as the federal funds rate set by a country’s central bank, have a greater impact on the overall interest rate environment.
The exact calculation of an interest rate is somewhat complicated, but can be simplified by using calculators. A simple example: If a loan has an annual interest rate of 5%, the formula is apr = p(1 + rt)/100.