Interest rates: what they are and how they work

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What is Interest Rate?

The interest rate is the cost you charge for borrowing money or the payment you receive for depositing or lending money.

You hear all the time about interest rates: the proposal for savings account flashes on the screen with the heading of an interest rate of 0.4 percent, or real estate agent says you can buy a house because interest rates are at an all-time low.

All of these interest rates are effectively reflected in the price of money. They dictate how much someone will pay to borrow money from you, or how much you pay to borrow money from someone else.

Whether you are looking to deposit or borrow money, your search should include researching a few key factors to ensure you can get the best deal. One of the most important pieces of the puzzle is the interest rate.

How interest rates work

When you receive interest on your deposit accounts, bank or credit union pays you. In exchange for these interest payments, the financial institution leverages these funds by lending them to someone else and charging interest on them. The bank charges a higher rate on this loan. Think of interest payments as part of that income.

How interest rates are determined

Interest rates on many financial products are tied to benchmark interest rates that drive economic growth and inflation… In simpler terms, lower benchmark interest rates stimulate the borrowing and spending activities that fuel the economy. Higher base rates help curb speculative activity that can fuel inflation.

For short term products such as savings accounts as well as CDsthen federal funds rate plays a central role. Federal funds rate is set The federal reserve, which meets eight times a year to assess the state of the economy and address any need for interest rate changes. For long-term loans and lending products, the rate the US government pays to get a loan is a key benchmark.

You also play an important role in setting the interest rate if you are dealing with money. When banks believe that you, as a borrower, are at greater risk, the interest rate rises to accommodate the institution’s heightened fears that you will not be able to repay the loan. If you have lower credit rating or you can afford to make only a tiny down payment, you will pay a higher interest rate than a borrower with a long and long life. strong credit history with a significant amount of money to be set aside.

How to earn interest

There is a wide range of banking products that can help you earn interest: some of them choose checking accounts, savings accounts, money market accounts as well as CDs… You will likely find higher interest rates on accounts with additional restrictions. For example, you will earn more by blocking your funds in 3 year old cd than you, putting them in account verification which allows you to withdraw an unlimited amount of funds.

Regardless of the type of account you want to open, online banks as well as credit unions usually offer the most competitive options for earning interest. Without the overhead associated with physical branches, online banks can afford to pay customers more. Online banking is just as safe like regular banks. Credit unions, meanwhile, are non-profit organizations owned by their members, and they can return profits to their members in the form of higher interest rates for depositors and lower interest rates for borrowers.

How interest works when you borrow money

When you borrow money, the lender gives you a certain amount of money and interest is charged on that number, called the principal, which increases the total amount you pay over the life of the loan.

For example, you are borrowing $ 200,000 to buy a home and the terms include an interest rate of 4 percent. Each month, a portion of your payment goes into equity – that’s the initial $ 200,000, and the other portion is monthly interest that is calculated from that 4 percent annual rate. Over the course of a 30-year loan, the interest rate matters a lot to the total amount you pay.

It is important to note that some interest rates are fixed and the rate will never change over the life of the loan. In other cases, the interest rate varies, which means that your rate will rise or fall with the market.

Annual interest rate and interest rate depending on the interest rate

Interest rates play a critical role in your finances. However, to get a complete picture of what you earn or what you pay, you focus on two acronyms: APR and APY.

  • APY stands for Annual Percentage Yield. This number reflects the difference in your ability to make money from your savings. This is the percentage you earn on your interest, assuming you reinvest it. If you are comparing savings products, you should focus on APY with one exception: if you plan to charge interest payments regularly. If you are retired or living on a fixed income and plan to use interest as regular income when it goes into your account, you will not benefit from compound interest.
  • Annual interest rate denotes the annual interest rate. It reflects the total cost of borrowing, including the interest rate and any fees incurred over the life of the loan. The difference can be felt, too. For loans with high start-up or recurring costs, the interest rate can be 3.5 percent and the annual interest rate is 4.5 percent.… Use this annual interest rate as a key comparison point to figure out how to make your borrowing better based on your overall budget.

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