Interest rates affect our everyday lives in a number of ways, from how much it costs to borrow money to how much we earn on our savings and investments. It’s important for everyone to understand how interest rates work so they can make informed financial decisions, whether they’re taking out a loan, saving for the future or investing in assets.
Interest is the amount paid or earned for the use of a sum of money, and it’s usually expressed as a percentage of the principal sum borrowed or deposited. Most loans are quoted with an annual percentage rate (APR), and some investment accounts may be described with an annual percentage yield (APY). APRs do not take compounding into account, whereas APYs do.
There are many different factors that influence the dynamics of interest rates, including creditworthiness and monetary policy. The latter is set by the Federal Reserve, and it influences how much businesses invest, individuals save, and the overall strength of the economy.
Generally, higher interest rates mean that it is more expensive to borrow money, while lower interest rates make it cheaper to do so. Ultimately, it’s the value that people place on having resources available in the future that drives interest rates. To illustrate this, Benjamin Franklin left $5,000 to two of his favorite cities and stipulated that they could withdraw the funds after one hundred or two hundred years. This is a great example of the power of compounding interest.