Interest rates are a key part of many financial transactions. They affect what it costs to borrow money, how fast a savings account grows, and the return on certain types of investments. Understanding how they work can help individuals make better financial decisions and manage their debt.
The interest rate is the amount paid by a borrower to a lender for the use of the latter’s assets. It is calculated as a percentage of the principal sum borrowed or lent, and it is usually expressed in annual terms. A borrower’s creditworthiness plays a significant role in the interest rate they receive; lower-risk borrowers typically get better rates. Economic factors like inflation and the relative scarcity of loanable funds are also major influences.
In general, the higher the interest rate, the faster a borrowed sum will grow. However, there are some exceptions. In the case of investments such as stocks and bonds, a higher rate may reduce the investor’s return because it compensates for the time value of money (the fact that the invested capital could be put to other uses in the meantime).
The exact formula used to calculate interest depends on whether the rate is simple or compounded. The latter takes into account the number of payments made over the term of the loan and may be used to determine an amortization schedule, which can help a person plan their budget or track the repayment of a personal loan.