Interest rates are one of the most important aspects of your financial life. They determine how much it costs to borrow money and how fast your savings or investments grow. They have a huge impact on the buying power of every dollar you save or spend, and they can even affect how much you need to put aside for retirement.
But how do interest rates work? And who sets them? This article helps explain what interest rates are and how they function in the real world. We’ll also discuss what factors influence interest rates, how they are measured, and what you can do to maximize their benefits.
A key point to remember is that interest rates aren’t the same thing as investment returns. The latter are based on your original capital investment and the return you get from that investment over time.
Interest rates, on the other hand, are applied to debt and calculated as a percentage of the loan’s principal. They are determined by a country’s central bank (e.g. the Federal Reserve in the United States) and banks use them to establish their APRs (annual percentage rates).
It’s also important to note that nominal interest rates are different than effective annual interest rates. The former is simply the rate that is quoted; it doesn’t take compounding into account. For example, a payday loan with a fee of $15 for a $100 debt will have an APR of around 400%.