How Interest Rates Work
In Simple Terms: Interest rates are the cost of borrowing money, or the reward for saving it. They're expressed as a percentage of the principal over a specific time period.
Types of Interest Rates
Simple Interest
Simple interest is calculated only on the original principal amount. It's
straightforward but less common in modern finance. Formula: I = P × r × t
Compound Interest
Compound interest is calculated on both the principal and previously earned interest. This creates exponential growth over time, making it powerful for long-term savings but costly for debt.
The Power of Compounding
$10,000 invested at 7% annual return:
Key Interest Rate Terms
APR (Annual Percentage Rate)
The annual cost of borrowing including fees. Used for loans and credit cards.
APY (Annual Percentage Yield)
The effective annual return including compounding. Used for savings accounts.
Prime Rate
The rate banks charge their best customers. Many loans are priced relative to prime.
Federal Funds Rate
The rate banks charge each other overnight. Set by the Federal Reserve.
What Influences Interest Rates?
- Central Bank Policy: The Fed raises/lowers rates to control inflation and employment
- Inflation: Higher inflation typically leads to higher interest rates
- Economic Growth: Strong growth may push rates up; recessions push rates down
- Credit Risk: Higher risk borrowers pay higher rates
- Loan Term: Longer terms often (but not always) have higher rates
How Rates Affect You
When Rates Rise ↑
- ✓ Higher savings yields
- ✓ CDs and bonds pay more
- ✗ Mortgages cost more
- ✗ Credit card debt grows faster
When Rates Fall ↓
- ✓ Cheaper to borrow
- ✓ Refinancing opportunities
- ✗ Lower savings returns
- ✗ Retirees earn less on fixed income