Interest rates are at the center of a wide variety of financial decisions, including whether to borrow money for purchases and investments and how much to save. Understanding how they work is essential to making smart financial decisions and managing your finances.
The word “interest” is derived from the Latin term for “profit.” Interest is a profit that is charged or paid on money borrowed. This profit is the primary way lenders earn income on their loans. Lenders set interest rates based on their assessment of the risk of lending to specific borrowers. For example, a borrower with limited or no credit history may be considered high-risk and thus be charged higher interest than someone with an established, strong credit profile.
When interest rates are low, consumers are more willing to borrow money for large purchases such as homes and cars, and this boosts spending throughout the economy. Businesses also benefit from lower rates because they can expand more quickly by borrowing to buy equipment and other assets.
When interest rates rise, it costs more to borrow, which reduces consumer spending and slows economic growth. This is the goal of the Federal Reserve when it raises rates to combat inflation or other signs of too-fast economic growth. Investors in bond funds and savings accounts also see their yields increase when the Fed raises rates. However, the higher rates can also lead to more market volatility as stocks and bonds sell off, hurting investor portfolios.