Every day on the news and in the newspaper, you'll see reports on how interest rates are doing. It's big talk about a very small and simple thing. An interest rate is how much money someone pays to borrow money. The reason it
Every day on the news and in the newspaper, you'll see reports on how interest rates are doing. It's big talk about a very small and simple thing. An interest rate is how much money someone pays to borrow money. The reason it's talked about so much is that this simple idea has many applications in the worlds of business, finance and government.
Interest is the cost of borrowing money. An interest rate determines exactly what that cost is. For example, if Bob lends $100 to Jill at 10 percent interest, Jill has to pay back $110. That's the easy part. Then there's compound interest, which has to do with larger sums borrowed over longer time periods. A car loan is a good example. Bob takes out an auto loan of $15,000 over a four-year period with an annual interest rate of 5 percent, and he makes monthly payments. He'll pay $345.44 per month, which includes--over the course of four years--$1,581.12 in interest. That's his cost of borrowing the $15,000.
The Federal Reserve
In the United States, the Federal Reserve Bank lends money to commercial and consumer banks. The Federal Reserve determines the rate of interest that banks pay for its money. This is known as the Annual Prime Rate (APR). Banks then turn around and lend to businesses and individuals, usually charging a little more than the interest rate set by the Federal Reserve.
Savings and Certificates of Deposit
The cost of borrowing money can work both ways. When people deposit their money into savings accounts or certificates of deposit, the bank is actually borrowing money from them. That's why these accounts receive interest. Typically banks pay close to the APR set by the Federal Reserve. They rarely pay more than their cost of borrowing from the Federal Reserve. Still, though, customers should shop around. Some banks try to attract new customers by paying higher rates of interest on accounts.
Interest rates are often discussed in the news as an indicator of the economy's performance. As a general rule, when the Federal Reserve lowers interest rates, it's trying to make sure enough cash is flowing through a sluggish economy. The idea is that the more money moved by businesses and consumers, the better the economy will function, which in turn will stimulate recovery. However, during healthy economies when cash flows are going well on their own, the Federal Reserve typically sets a higher interest rate. Many people look at the interest rate as an indication of which way the economy is headed.
Loans, Mortgages and Credit Cards
Businesses and consumers most often feel the effects of interest rates on their loans. Commercial loans are a common way small businesses get start-up capital and often how they finance change, growth and improvements. For consumers, mortgages, car loans and credit cards are common forms of borrowing. Interest rates matter because they determine monthly payments and whether or not an organization or individual can afford to borrow money. Traditionally when interest rates have dropped, consumers have refinanced their homes to get lower interest rates on mortgages--making their house payments more affordable. In a tight credit market, refinancing may be more difficult, but there's the option of seeking loan modifications in order to keep up with payments.
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