Interest rates play an important role in our daily lives, from securing a mortgage or managing credit to building savings in a bank account. Understanding how they work is key for individuals to understand the financial landscape and take control of their own finances.
An interest rate is the price an entity pays to borrow money or the fee it earns for lending it, expressed as a percentage of the principal. It’s usually noted on an annual basis and is referred to as an annual percentage rate (APR). Interest is also applied to deposit accounts at banks or credit unions, such as savings or certificates of deposit (CDs), and is known as the annual percentage yield (APY).
There are two types of interest: simple and compound. Simple interest is a calculation that doesn’t consider the amount of interest earned or paid in previous periods, so it’s typically used for short-term loans and investments where interest doesn’t compound over time. Compound interest, on the other hand, is a formula that takes into account all of the interest earned or paid in previous periods. This allows for greater investment growth over time and is commonly used for long-term loans and investments, such as a mortgage or retirement savings plan.
Different types of loans and investments have a variety of factors that impact their interest rates, including the risk profile of the borrowers or investors and the purpose of the loan. Regardless of the type of investment or loan, individual consumers should always shop around and compare their options to find the best deal.