When it comes to borrowing or saving money, interest rates are a key factor to consider. They determine the true cost of loans, credit cards and even home mortgages. But with so many different kinds of interest rates, how do you know which one to choose?
The term “interest rate” refers to either what lenders charge borrowers for borrowing their money or the fee they earn on deposit accounts such as savings accounts and certificates of deposits (CDs). It is also commonly used in macroeconomics to describe a central bank’s policy rate, such as the Federal Reserve’s Federal Funds Rate.
A key factor in the determination of interest rates is the demand for funds from both businesses and individuals. When the economy is strong, the desire of businesses to invest in equipment and consumers to purchase houses tends to push interest rates up. By contrast, periods of weak economic conditions lead to lower demand for funds and therefore lower interest rates.
In addition to the factors mentioned above, individual lender or creditor factors may also be taken into consideration in determining your interest rate, such as your creditworthiness. Banks and other financial institutions will look at your credit score and other financial documents to determine how likely you are to pay back the loan or credit card debt they lend you.
A third factor in the calculation of interest rates is the risk that the lender will not be repaid, and so may add a risk premium to the actual interest rate they are charging. This is a way to reward those that take on more risk and compensate those who are less willing or able to take on such risks.
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