Interest rates are involved in almost all formal lending or borrowing transactions, from a mortgage to the amount charged on an outstanding credit card balance, and the growth of retirement savings or investment accounts. Understanding how interest rates work can help you manage your personal finances and make more informed financial decisions.
Interest is the price paid by a borrower to use funds provided by a lender or the compensation earned by investors for the temporary use of their money. It is typically expressed as a percentage of the principal amount (i.e., $100 borrowed at 5% for one year will obligate the borrower to pay $5 of interest).
For lenders, the financial risk premium in an interest rate is a function of the debt-to-asset ratio. A greater debt-to-asset ratio translates to lower equity, meaning the lender has less buffer against losses and thus needs higher interest rates to compensate for this increased risk.
In addition, interest rates are influenced by the state of the economy. Typically, when interest rates are high, consumers and businesses find it expensive to borrow, which decreases consumer demand and slows economic growth. Conversely, low interest rates make it easier for people to spend and for businesses to invest, which stimulates the economy.