Interest rates are the topic of many conversations, because they’re important to both the economy and your personal finances. Understanding how they work can help you make informed financial decisions.
Lenders and credit card companies use an annual percentage rate, or APR, to calculate the cost of borrowing money. This formula applies to both simple and compounding interest: n = principal
A lender’s interest rate is determined by a number of factors, including its own assessment of a borrower’s creditworthiness and the length of the loan or credit. Lenders also take into account economic trends when setting its rates.
For example, if the Fed lowers its benchmark interest rate, known as the federal funds rate, then other banks’ variable interest rates will likely fall as well. This could mean potential savings on loans or a lower monthly payment for credit cards. However, the potential savings aren’t guaranteed and may be dependent on your specific circumstances.
Low interest rates stimulate the economy by allowing consumers to access loans at inexpensive rates and encouraging individuals to invest in riskier investments, like stocks. These investments increase spending, which can boost demand and drive growth. However, these gains may eventually lead to market disequilibrium and inflation, as Walras’ law states that prices must rise when demand exceeds supply. Eventually, governments must raise interest rates to prevent inflation and restore a healthy economy.