When you take out a loan, invest in a savings account or money market fund, or use any type of credit card, you are paying or earning interest. The rate at which you pay or earn interest can save or cost you thousands or tens of thousands over the life of the loan or investment. Understanding how rates work is an essential financial skill.
Interest rates can be simple or compound, and they can be fixed or variable. Fixed rates stay the same over the length of the borrowing term, while variable rates fluctuate during the borrowing period at pre-determined intervals (e.g. monthly, daily or annually).
The prevailing economic conditions are one of the most important influences on interest rates. In periods of strong economic expansion, businesses’ desire to invest in plants and equipment and individuals’ desire to buy homes drive interest rates up. Conversely, during weak economic conditions, companies’ and households’ desire to save drives interest rates down.
Personal factors also influence interest rates, such as your creditworthiness and the criteria lenders consider when deciding to offer you a loan or credit card. For example, banks consider your FICO credit score and other financial documents to determine whether you qualify for a mortgage or to borrow at a certain rate. Borrowers can try to get a better rate by doing their research and shopping around before accepting a loan or credit card. They can also try to borrow during opportune moments, such as when the economy is growing or slowing down and when interest rates are low.