Interest rates are at the heart of most financial conversations – you may hear your peers talking about how much they owe on their mortgage, credit card and car loans as well as their savings account rates. However, many people don’t fully understand how they work. The good news is that there are ways to learn more about these important financial metrics so you can take control of your money and invest in the right opportunities.
Generally, interest rates are determined by the economy. When demand for borrowing and depositing is high, banks raise rates to attract more borrowers and retain current ones. Conversely, when the economy is slow, interest rates fall to encourage more spending and investment in riskier ventures such as stocks.
Other factors include the type of debt and whether it’s secured by collateral. Mortgage loans, for example, usually have lower rates than credit cards and personal loans because they’re backed by the equity of a home, which lenders can sell to cover their losses if the borrower defaults on the loan.
Additionally, investors can determine the real and nominal rate of return on their investments by comparing the buying power of the principal sum against the buying power of the amount lent, deposited or invested. This calculation is called the Fisher equation, and it takes inflation into consideration. It’s also possible to calculate the annual percentage yield (APY) of a savings account, which takes compounding into consideration.
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