Interest rates are a fundamental part of the financial landscape and play an important role in our lives. They influence the borrowing costs of individuals and businesses, which can affect their spending decisions. They can also help to control inflation by tightening the money supply. The Federal Reserve seeks to set interest rates that will create the conditions needed to meet Congress’s mandate–to promote maximum employment and stable prices.
The amount of interest paid or earned on a loan is the product of the principal and the interest rate, which is generally noted as a percentage. It is often referred to as the annual percentage rate (APR) or the interest rate on an installment loan such as a mortgage, and as the Annual Percentage Yield (APY) for savings accounts at banks and credit unions, and certificates of deposit (CDs).
Lenders use different criteria to decide what rate to charge borrowers or what they should earn on deposits, including their overall creditworthiness, which may be assessed by looking at FICO scores and credit reports. The type of loan or investment can also impact the interest rate, for example, a mortgage has different risk characteristics than unsecured loans like credit cards.
How an interest rate is calculated can also make a difference, with simple interest applying the same formula to the principal each time and compounding interest applying it not just to the current principal but also to the accumulated interest from previous periods. The latter is typically more favorable for investments, but simpler interest can be more advantageous when borrowing money, depending on the needs of the individual.
