What Are Interest Rates? 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 of principal charged by the lender for the use of its money. The principal is the amount of money lent. Banks pay you an interest rate on deposits because they borrow that money from you.

Anyone can lend money and charge interest, but it's usually banks. They use the deposits from savings or checking accounts to fund loans. They pay interest rates to convince people to make deposits.

 

Banks charge borrowers a little higher interest rate than they pay depositors so they can profit. At the same time, banks compete with each other for depositors and borrowers. That competition keeps interest rates in a narrow range

How Do Interest Rates Work?

The interest rate is applied to the total unpaid portion of your loan or credit card balance. It's important to know what your interest rate is and how much it adds to your outstanding debt. For example, if you pay less than the interest rate, your debt will 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. 

Banks can charge fixed rates or variable rates, depending on whether the loan is a mortgage, credit card or unpaid bill.  Here's how these interest rates are determined.

What Is the APR?

The APR stands for annual percentage rate. It allows you to compare the cost of different borrowing options. The APR includes any fees a bank may charge. These one-time fees are called "points" because they are also calculated as a percentage point of the total. The APR can help you compare a loan that only charges an interest rate to one that charges a lower interest rate plus points.

Interest Rates Drive Economic Growth

A country's central bank sets interest rates. In the United States, the fed funds rate is that guiding rate. It's what banks charge each other for overnight loans. The Federal Reserve requires banks to maintain 10 percent of total deposits in reserve each night. Otherwise, they would lend out every single penny they have. That would not allow enough of a buffer for the next day's withdrawals. The fed funds rate affects the nation's money supply and thus the health of the economy.

Interest rates make loans more expensive. When interest rates are high, 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 because they receive more on their savings rate.

 High interest rates also reduce the capital available to expand businesses, strangling supply. This reduction in liquidity slows the economy.

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. Savings rates fall. 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. That drives up stock prices. Low interest rates make business loans more affordable. That encourages business expansion and 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 Fed prefer low interest rates. But low interest rates can cause inflation. If there is too much liquidity, then demand outstrips supply and prices rise. That's just one of the two causes of inflation