Interest rates are a measure of the cost of a loan to a borrower.
Typically expressed as a percentage, an interest rate is applied to the outstanding balance of a loan at regular intervals. Interest rates can vary broadly from product to product and from borrower to borrower.
When a borrower takes out a loan, they must repay the principal value of that loan and make interest payments to the lender. These interest payments are based on an annual rate applied across the balance of the loan for its duration.
Lenders determine interest rates and payment plans based on the purpose of the loan, the financial stability of the borrower and broader market conditions. That means every transaction involves a different, bespoke interest rate. For example, the same borrower going to the same lender for the same product could see a different interest rate tomorrow than they would today.
A good rule of thumb is that riskier loans tend to carry higher interest rates.
Sometimes this risk comes from the borrower. Consumers with low credit scores or poor financial histories are charged higher interest rates, and the same holds true for businesses that have low credit ratings.
Another factor is the duration of the loan. A loan that lasts only a few years naturally has a higher chance of repayment since there is less time for unexpected difficulties to arise.
The broader lending and interest rate environment also affects rates. If loans are being readily repaid, banks may compete to offer lower rates to win new business. But if things are less favorable, banks may charge higher rates to offset the risk of potential losses.
If you take out a $120,000 loan over 10 years at a 0% interest rate, you'll pay $1,000 per month for 120 months, as there are no additional costs. But that's not how banks work, and just a few percentage points of interest can add up in a hurry to increase the total cost of a loan.
For example, the same loan at a 5% interest rate paid over 10 years will cost you about $1,273 per month, or more than $32,000 in interest payments beyond your $120,000 principal amount. A 10% rate on that same amount costs you about $1,586 per month and more than $70,000 in total interest charges.
Interest rate calculators can be helpful in determining payment breakdowns month to month.
Most individuals are familiar with interest rates as borrowers. But even if you're not running a bank, you can also be a "lender" by participating in interest-bearing investments such as bonds.
In this scenario, you get the interest payment as investment income. An investment with a higher interest rate will pay you more via regular distributions from the borrower.
Keep in mind that the same risk-reward trade-off exists here, too. A higher interest rate on a bond investment may pay you more while the borrower remains solvent, but those high rates tend to exist because there is a higher chance that they will default on the loan and ultimately pay you nothing after they go belly up.
The U.S. Federal Reserve controls a powerful benchmark rate known as the federal funds rate, which is usually what Wall Street analysts mean when they refer to the Fed making changes to rates. However, the federal funds rate can remain fixed at the same level for years at a time, so real-time borrowing costs may be better determined by other metrics that are more fluid.
One key metric is the rate on 30-year fixed mortgages, one of the most common forms of housing loans. Another is the 10-year U.S. Treasury bond, which is a widely held asset that affects interest rates across a host of other financial products. Then there's the prime rate, which is shorthand for the rate on loans to the most creditworthy consumers and businesses in the U.S.
Debt is seen as a dirty word sometimes, as it can be synonymous with irresponsible spending. But that's a gross oversimplification because it's also the lifeblood of the economy. Without loans, few consumers would be able to buy a home, go to college or finance a small business.
Interest rates are a crucial part of the lending complex, and thus can tell us a lot about the health of the U.S. economy. While it's always important to understand your interest payments as a borrower or your rate of return as an investor in interest-bearing assets, it's also important to understand the broader environment as an indicator of the financial health of the nation.
FAQs
The U.S. Federal Reserve has direct control over the key federal funds rate. This rate affects the overnight lending rate for major financial institutions. The Fed uses monetary policy such as this rate to affect the movement of cash at the highest levels and to influence employment, inflation or other factors.
Not always. In some circumstances, moderately higher interest rates can be an indicator of financial health. That's because borrowers may be able to shoulder higher costs. Of course, if interest rates go sky high, then economic activity grinds to a halt because borrowers are scared off altogether. There's a lot of gray area on what interest rate is "too high."
During the worst of the financial crisis, some European markets saw negative interest rate environments. This was because banks were charged for their excess reserves rather than getting a positive payment for them, an extreme measure taken by central banks in the region to discourage institutions from sitting on their cash. Such occurrences are rare.
