Whether it’s a mortgage, car loan or credit card debt, a variety of factors shape interest rates. Understanding how these factors impact interest rates can help you manage your finances and make smart financial decisions that align with your goals.
Interest is a cost paid by borrowers for borrowing money or an amount earned by depositors when they invest their savings. It’s typically expressed as a percentage of the principal sum—or the original amount of money involved in the transaction—over a set period of time, usually a year.
The cost of interest reflects two main considerations: risk and the value of time. Amounts of money available now are worth more than those in the future, due to inflation and opportunity costs (the potential earnings lost by investing the funds elsewhere). So, lenders charge interest to cover their risk and reflect this loss of buying power.
As such, the more long-term a loan or debt is, the more risky it is, and therefore the higher the interest rate. On the other hand, shorter loans and debts have a lower risk profile, so they tend to have lower interest rates.
Interest rates also fluctuate according to the state of a country’s economy. For example, when a country’s central bank sets low interest rates, people are encouraged to borrow and spend. This stimulates the economy and provides an injection to capital markets, driving economic growth. However, as the economy expands, demand for goods and services can quickly outpace supply, leading to inflation.