Interest rates are a central part of the financial world, whether you’re borrowing money or investing it. They affect how much you pay or receive for the amount you lend or invest, as well as how quickly your savings grow and your buying power in your bank account. But they can also be confusing. This article dives into how interest rates work, why they change and what you can do to prepare for them.
A lender or creditor determines what interest rate to charge based on various factors, including your “creditworthiness”—that is, the likelihood that you’ll repay your debt on time. A person with a higher credit score is typically considered less risky and can qualify for lower interest rates. Other personal factors may include the loan repayment term, amount borrowed, collateral and down payment. Economic trends and market benchmarks, such as the federal funds rate set by the Federal Reserve, can also influence interest rates.
In addition to the principal sum, the amount of interest accumulated and paid is determined by compounding frequency, length of period and inflation (or lack thereof). Inflation-adjusted or real interest rates are calculated using formulas that take inflation into account.
The relationship between bond prices and interest rates is inverse: When rates rise, bonds that pay a low coupon become less attractive to investors, while new bonds issued at the higher rate can offer a more lucrative return. But a long-term investment horizon and proper diversification can help minimize the impact of short-term changes in interest rates.