Interest rates play critical roles in borrowing, managing debt and building savings. Understanding how they work can help you make savvy financial decisions that fit your life and goals.
In borrowing, an interest rate reflects the cost of debt for borrowers and a return on investment for lenders and savers. It’s usually expressed as an annual percentage of the principal amount of a loan or investment.
The nature of a particular type of debt or savings instrument influences its interest rate, with mortgages and car loans having higher rates than credit cards and personal loans that aren’t secured by a piece of property. That’s because the lender can foreclose or sell a home or car to reduce losses in the event of default. The duration of a loan, whether it’s fixed or variable, and the purpose of a savings account or other deposit product also affects interest rates.
Economic theories that explain interest rates differ, with some suggesting that a positive return is necessary to encourage saving and others pointing to the balance between money supply and demand. Whatever the cause, persistently low inflation in many advanced economies appears to have lowered markets’ long-term expectations of interest rates, and that could have implications for spending and saving behavior.
When choosing between a fixed or variable rate, consider your tolerance for risk and your overall financial goals. For example, a fixed rate can provide stability, but it won’t benefit you if interest rates go down. A variable rate, on the other hand, can offer a more competitive offering in the short term.