Interest rates are a crucial part of many financial transactions, including the cost of debt for borrowers and the returns on investments for savers. They are influenced by a variety of factors, ranging from personal characteristics like creditworthiness and income to economic trends such as inflation and government monetary policy.
The most important factor is the general willingness of individuals, businesses and governments to borrow money and invest it. Generally speaking, higher demand for funds tends to push up interest rates and lower demand can drive them down.
To determine what is a reasonable price to pay for the use of resources, a lender must consider several factors: the relative value of different forms of money, the time value of money (the fact that the present value of cash in hand is less than its future worth), and the taxes that may be due on gains from interest payments. Another factor is liquidity preference, a basic human tendency to prefer the availability of liquid assets that can be easily exchanged for other goods and services.
The rate of interest is often expressed as a percentage, typically over a specific period, known as the loan or investment term. For example, when shopping for mortgages, you’ll see annual percentage rates, or APRs, advertised. This is a standardized way of reporting the interest on loans and can help you compare similar products. However, APRs do not always take into account compounding. Banks and credit unions also pay interest on savings and certificates of deposit (CDs). This is usually quoted as an annual percentage yield, or APY, and takes compounding into consideration.
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