Interest rates shape the financial landscape and should always play an important role in personal finance decisions, whether you’re seeking credit, managing debt or building savings. Understanding how interest rates work can save or cost you thousands (or tens of thousands) over the life of a mortgage, car loan or credit card balance.
During periods of lower policy interest rates, people are more likely to borrow money and spend it. This increases demand for products like cars and homes, which in turn stimulates economic activity by increasing manufacturing output, hours for factory workers and commissions for salespeople.
When interest rates rise, it can make it harder for consumers to pay off existing debt and can reduce the incentive to save money, which tends to slow economic growth. In addition, higher rates can boost profits for companies that borrow to invest in equipment, which in turn can lead to a hiring boom.
Different types of loans have different risk profiles and therefore come with a range of interest rates. For example, a mortgage loan is secured by real estate, which can be sold to offset losses if the borrower defaults, so typically has lower rates than unsecure loans such as credit cards.
When comparing offers from banks, credit unions and neobanks, remember that the advertised rate doesn’t take compounding into account. The annual percentage yield, or APY, that a bank may pay on a savings account or certificate of deposit (CD) does take this into consideration and is a better indicator of the true cost of borrowing or earning.