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An interest rate is the rate at which interest is paid by a borrower (you) for the use of money that they borrow from a lender (typically the bank). In other words, you need to pay the bank a certain amount of money, in addition to your monthly payments, for allowing you to take out a loan.
Interest rates are determined before you take out the loan, so you will know what to expect before signing on the dotted line. Interest rates are typically expressed as a percentage of the principal, the amount of money you are borrowing, for a period of one year. The current financial market of the country dictates whether interest rates are high or low.
If a country wishes to increase investment in the economy, the government might reduce interest rates in order to make loans more affordable for the masses. However, low interest rates can be risky and may lead to the creation of an economic bubble due to large amount of investments being poured into the real estate and stock market - as evidenced by the recent Great Recession in the U.S.
Not surprisingly, setting interest rates is a balancing act of sorts. Borrowers want low rates, because less money comes out of their pocket, but the government needs to make sure rates are at a reasonable level in order to ensure economic security.
Interest Rates and Loans
If you are interested in taking out a loan and have been shopping around, you have probably noticed that different banks or credit unions offer different interest rates or deferred interest. Although the advertised interest rate is influenced by many factors, such as the state of the economy, the expectation of inflation in the future, and alternative investments, one of the most important is the element of risk.
It should come as no surprise that the riskier the loan, the higher the interest rate. If the lender thinks there is a possibility you will not pay off your loan when you say you are going to, you will need to pay a larger sum of money in order to borrow the desired funds. Very volatile investments, such as shares of stock or a bond that is rated below investment grade, will have higher returns than safer ones such as bonds issued by the government.
Before you take out a loan, it is important to make sure you can afford both the principal amount and interest payments. Some people fail to think about how interest will affect their budget, so a loan that was intended to provide financial relief actually ends up being a financial burden.
It is wise to do your homework and make sure you are making a sound investment that will benefit you in the future. If you're looking for a quick fix, there are plenty of short-term, unsecured loan options available, but be prepared to pay through the nose in interest - rates can sometimes reach triple digits!
The Takeaway Message about Interest Rates
In the end, interest rates are the price of living in a world that is based heavily on credit and debt. Interest rates are one of the main reasons why lenders allow you to borrow money, so they don't just exist to cause another monetary headache. Think about it - if you could never take out a loan, how would you pay for college, buy a house, or even shop online with a credit card?
In many ways, interest rates provide the foundation for several of the advantages of living in a world with available credit. If you are in good financial standing and your credit score is solid, you can expect the interest rates offered to you by lenders to be lower than potential borrowers with a shaky past. It is also important to remember that interest rates should be thought of as a two-way street.
Financial institutions also need cash, so if you put money into a savings account at a bank, the bank will pay you interest for allowing them to temporarily use that money. If you are interested in taking out a loan, remember that interest rates are not random and they are not designed to punish you. In order to borrow money, interest rates provide the security measure a lender needs to hand you funds when you need them most.