Interest rates play a big role in everyone’s financial life, from the buying power of each dollar in your bank account to the amount of money you need to save for retirement. But the way interest is calculated can be confusing, with different terms and formulas for calculating the amount of money paid or earned on each loan or investment.
Generally, higher interest rates make it more expensive to borrow money or invest in financial products. Lower rates, on the other hand, can encourage borrowing and spending, which helps support economic growth.
While many factors that influence interest rates are uncontrollable, individuals can take steps to minimize their impact on their financial situation. For example, borrowers can shop around for the best loan rates, and investors can craft a bond ladder to reduce exposure to rising interest rates.
The current interest rate environment has gotten a bad rap, and rightly so. High interest rates are to blame for skyrocketing borrowing costs on mortgages, credit cards and student loans, which can put a strain on households. They can also hinder businesses’ ability to finance growth by restricting access to debt financing, slowing economic activity.
In a typical economy, the central bank sets an interest rate that influences the rates banks charge each other for short-term loans. This is called the target federal funds rate, which doesn’t have the same effect on the interest rates people pay or earn on loans from other lenders or savings accounts at banks, but it can influence them. Another important rate is the real interest rate, which takes inflation into account to determine the actual return on assets.