Interest rates are at the heart of most lending or borrowing transactions, from mortgages and car loans to savings accounts and investments. The state of interest rates influences how much it costs to borrow or earn on an investment, affecting the purchasing power of every dollar in your bank account. They also influence the amount you need to save for retirement or other long-term goals. Interest rates are often discussed in the news, and they may even make headlines for good or bad reasons.
When interest rates rise, it typically indicates a strong economy, while falling rates usually signal a weaker one. They also have a big impact on the banking industry, as banks typically make more money when they loan money to businesses and individuals than when they hold assets like certificates of deposit or Treasuries. Interest rates are largely driven by monetary policy, and the Federal Reserve sets them to help achieve its congressional mandate to promote maximum employment and stable prices.
There are a number of factors that influence interest rates, including inflation and the supply and demand for money. Borrowers want low rates so it’s less expensive to take on debt, while investors seek high returns on their investments. The real or effective annual interest rate reflects the total cost of borrowing (or return on investment) and takes into account factors such as compounding frequency and length of term. For example, a bank may advertise a nominal interest rate of 5% per year on a savings account, but this ignores inflation and fees.