Interest rates are a key factor in financial decisions ranging from buying a car or a home to saving for retirement. They make it easier or harder to borrow money and can significantly impact the buying power of the money saved or invested.
Interest rate refers to the price paid to an entity for lending its money, usually reflected in a percentage. It applies to loans such as credit cards and mortgages as well as savings deposits like certificates of deposit and savings accounts. There are two main types of interest: simple interest computed on the principal amount and compound interest that takes accumulated gains into consideration.
Central banks change interest rates to achieve macroeconomic goals such as achieving price stability and full employment through encouraging borrowing and investment. Lower interest rates stimulate borrowing and economic activity by making it less expensive for consumers and businesses to obtain loans such as mortgages, auto and student loans. Conversely, higher interest rates restrain spending by consumers and businesses by making it more expensive to borrow money.
In addition, the level of inflation has a significant influence on interest rates. Inflation causes prices to rise for goods and services, which makes it more costly to repay debt that has been incurred with the purchase of those goods and services. This is why monetary policy makers tend to increase interest rates during periods of high inflation to discourage borrowing and spending, while decreasing rates in times of low inflation to encourage borrowing and growth.