Interest rates are a part of daily life: Consumers consider them when choosing a loan or credit card, investors watch them as indicators of economic growth and businesses plan for their future, while the Federal Reserve adjusts them to keep the economy running smoothly. However, many people don’t fully understand what determines the exact rate they pay or earn on their loans and investments.
Essentially, the interest rate is the cost of borrowing money or the price paid to borrow it, usually expressed as a percentage of the principal amount borrowed. It is calculated annually, though it can be applied to a shorter time period, such as a month or a day. A borrower will typically pay more interest if they borrow over a longer period of time.
There are a variety of factors that determine interest rates, including how strong or weak the economy is and the desire of consumers, businesses and governments to save or spend more than they take in as income. However, the most influential factor on an individual basis is a person’s creditworthiness. Lenders review a person’s FICO credit score, bank statements and other financial documents to gauge how likely they are to repay their debt and thus pay the interest rate charged to them.
Another factor that influences interest rates is whether it’s a fixed or variable rate. Fixed rates are set at a certain percentage for the entire duration of the loan or investment, while variable interest is compounded more frequently and therefore grows faster. A person who borrows $100,000 at a simple interest rate of 10%, for example, will end up owing the bank $120 a year later—$100 for the principal and $10 for the interest.
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