Interest rates affect everything from the cost of borrowing to the return on savings. Understanding how interest rates work can make you more confident in your financial decision-making—whether securing a mortgage, acquiring credit cards or building savings.
A key part of any formal lending and borrowing transaction is the payment of interest—the reward for deferring the consumption of resources until a later date. Interest rates are determined in a free market by supply and demand, with the demand driven by the desire of households and businesses to spend more than they take in as revenues and the desire of governments to borrow money for capital projects.
The actual rate of interest you pay depends on the type of loan and the lender’s risk profile. Generally, secured loans, such as a home mortgage, have lower interest rates than unsecured loans, such as personal credit card debt. The length of the loan also impacts the interest rate, as longer-term loans are a greater risk to lenders.
The true cost of a loan is typically calculated as the annual percentage rate (APR), which includes other fees and charges. Lenders are required to disclose their APR on loan estimates, which gives borrowers a complete picture of the cost of a loan and enables them to compare competing loans. Interest payments can add up to thousands, if not tens of thousands, over the life of a large loan, such as a mortgage. That’s why it’s important for borrowers to research and shop around for the best possible rates.