What Are Interest Rates and How Do They Work?

interest rates
Low interest rates make buying a house more affordable. Photo: Solina Images/Getty Images

Definition: The interest rate is the percent charged, or paid, for the use of money. It is charged when the money is borrowed, and paid when it is loaned. The interest rate that the lender charges is a percent of the total amount loaned. Similarly, the interest rate that an institution, such as a bank, pays to hold your money is a percent of the total amount deposited.

Anyone can lend money and charge interest, or hold deposits and pay interest.

However, it's usually the function of banks to make loans or hold deposits. How do banks get the money to make loans? Banks use the deposits made by people who keep their savings or checking accounts with them. Banks convince people to make deposits by paying interest rates. Banks are paying depositors for the right of using their money.

Banks then use that money to make loans. Banks charge borrowers a little higher interest rate than they pay depositors for that same money so they can profit from providing these services. Banks want to charge as much interest as possible on loans, and pay as little as possible on deposits so that they can be more profitable.

At the same time, banks compete with each other for those same deposits and loans. That keeps interest rates in a similar range. For more, see How Interest Rates Are Determined.

How Do Interest Rates Work?

Interest rates are charged not only for loans but also for mortgages, credit cards and unpaid bills.

The interest rate is applied to the total unpaid portion of your loan or bill. It's important to know what your interest rate is, and how much it adds to your outstanding debt. If your interest rate adds more to your debt than the amount your are paying, your debt could increase even though you are making payments.

Although interest rates are very competitive, they aren't the same. A bank will charge higher interest rates if it thinks there's a lower chance the debt will get repaid. Some types of loans, like credit cards, are always assigned higher interest rates because they are more expensive to manage. Banks also charge higher rates to people they consider risky. That's why it's important to know what your credit score is, and how to improve it. The higher your score, the lower the interest rate you will have to pay.

What Is the APR?

The APR stands for Annual Percentage Rate. That allows you to compare what your actual cost is for borrowing, or what your real return is for lending. That's needed because some lenders charge more than just the interest rate. They may also charge a one-time fee that is also a percent of the total loan.

These one-time fees are called "points" because they are figured as a percentage point of the total. The APR takes these points and any other costs into account. It is helpful when you need to compare two loans, one that only charges an interest rate, and one that charges perhaps a lower interest rate plus points.

Interest Rates Drive Economic Growth

A country's central bank is responsible for setting interest rates. For example, the U.S. Fed funds rate is the amount banks charge each other for overnight loans. These loans are necessary because banks must have 10% of total deposits in reserve each night. Otherwise, they would lend out every single penny they have on deposit. That would not allow enough of a buffer for the next day's withdrawals. It's a significant interest rate, in that it affects the entire supply of money, and hence the health of the economy.

The interest rates that banks charge make loans more expensive. When interest rates are high, that means fewer people and businesses can afford to borrow. That lowers the amount of credit available to fund purchases, slowing consumer demand. At the same time, it encourages more people to save (if they can) because they receive more on their savings rate. Higher interest rates also reduce the capital required to expand businesses, strangling supply. This reduction in liquidity usually slows the economy down.

As you would expect, low interest rates have the opposite effect on the economy. Low mortgage rates have the same effect as lower housing prices, stimulating demand for real estate. When savers find they get less interest on their deposits, they might decide to spend more. They might also put their money into slightly riskier, but more profitable, investments -- thus driving up stock prices. Low interest rates make business loans more affordable. That encourages business expansion, and creates new jobs.

If they provide so many benefits, why wouldn't you just keep rates low all the time? For the most part, the government and Federal Reserve prefer low interest rates. However, low rates for too long can cause inflation. That's because, if there is too much liquidity, then demand outstrips supply, and prices rise. For more, see Causes of Inflation.  

Examples: High interest rates cause a recession.

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