What Are Interest Rates And How Do They Work?

Interest rates are something you probably hear about almost every day in many ways. First, you get your credit card bill and you see that the interest rate is part of your bill. Or, you are watching the news and they are talking about the Feds raising the rates and causing the stock market to go down, or maybe you have an interest bearing savings account at your bank. What are all these rates and how do they get picked? How and why do they go up or down?

What Are Interest Rates?

An interest rate is what a borrower pays so he can get the money needed to buy something over time. It’s a percentage of the amount of the money being borrowed, which is the principle, while the interest rate is the extra you pay for the privilege of borrowing the money. So, if the interest rate is 10 percent and you borrow $1,000 then you’d pay $100 in interest over a certain period of time.

Things that affect rates of interest:

Credit Score — The rates are a lender’s compensation for risking their funds that they allow a borrower to use and then pay them back. So, if the risk is high that the borrower won’t pay back the loan, then they usually have to pay a higher interest rate to borrow the money. So, that’s why it’s vital for you to have a high credit score. That way you won’t pay such high rate of interest.

Unsecured vs. Secured Credit — The borrower’s credit score is only one kind of risk factor affecting the rates. If they borrow money for an unsecured loan that has no collateral, then the interest rate is always higher. But, if the loan is for something like a car, for example, it is secured with collateral because the company can take back the car if the person doesn’t pay the loan. Then, that makes the interest rate lower since the car can be taken back and the risk is not as great.


Inflation — Another issue affects the rates of interest is inflation. If the economy is going well, inflation rises and the money isn’t worth as much when you buy something. So, that usually also makes the  rates go up as well. Inflation is the percentage of the rise of the cost of things and is measured as a yearly percentage every year.

Two Kinds of Rates

There are two kinds of calculated rates: nominal and real. The nominal interest rate is the one the banking institution sets, while the real interest rate is the nominal rate minus the inflation rate. Here is an example, if you get a loan that has a nominal interest rate of 10 percent, and the inflation rate for the year is four percent, then the lending institution is actually getting about a six percent interest.

How the Federal Reserve Affects Rates of Interest

Another important factor when it comes to setting rates is the US Federal Reserve. This is the central bank in the US, which was created by Congress in 1913. It was created to make the US economy more stable and secure. The US Treasury uses it to raise cash for the government by selling government bonds and securities to investors.

Plus, it aides the commercial banks in the US with needed cash reserves. Regular banks have to have a certain amount of money in their cash reserve to cover themselves in case a bunch of people suddenly want lots of money from their accounts all at once.

So, the Federal Reserve works to keep things stable and moderates all the rates that are long term. They do this based on calculations that determine the state of the economy. They also try to curb inflation. So, the bottom line is that the Federal Reserve uses interest to influence lending and borrowing of money through banks, etc. If the banks have a lot of cash reserves, the rates are lower than if they don’t have a lot of cash reserves.

Rates of Interest And The US Economy

The US economy is ever changing and when the Federal Reserve makes a change in the rates of interest that they charge to the lending institutions, that is of course passed on to their clients and everyone in the economy in one way or another in the cost of things.

Here is an example. If the Federal rate goes down, banks and other lending institutions pay less rates of interest on the cash they borrow. If they lower those interest rate to their customers, then more people will want to borrow money from them. Then they will spend more money and the economy will grow.

This also affects the stock market because it goes up if the interest rate goes down or they even sometimes think they might go down. This is because they know that lower interest rate makes people buy more goods and services since it cost less to borrow the money to get them.

The dollar is also worth less overseas if the federal rate is low, and this can be bad for the US economy because if the dollar is worth less, the goods to make things costs more and the manufacturers have to pay more and then raise their prices, which of course makes the client’s and customers have to pay more in the long run.

All in all interest rates are an important thing that in some ways literally run the world because it affects all of the products and services bought and sold all over the world. So, the next time you are considering to buy a car or a house, and they tell you how much the interest rates are, then you will understand better why they are the amount that they are at that time. This may help you decide whether to borrow money now or wait until a better time when interest rates are likely to go down, thus making your item cost less.

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