Interest rates are the subject of much discussion in the financial news and are often a topic of conversation when people discuss their personal finances. They are important because they influence how much you pay for loans such as a mortgage or auto loan, how much money your credit card debt grows, and how well your savings account or investment accounts grow over time. This article will explore the definition of interest and some common types of interest rates including simple interest and compound interest.
Interest is a fee paid or earned for the use of an asset, expressed as a percentage of the principal. For example, if you borrow $1000 from a bank to purchase a car and you pay 5% interest, the lender will make a profit of $5. This is because they are charging you for the use of their assets (the car) which they could have invested in and earned income from instead.
Low interest rates encourage individuals and businesses to spend more, increasing economic growth. This is because the availability of inexpensive money provides an injection into capital markets, allowing businesses to invest more in expanding their operations and stimulating demand for goods and services. Conversely, higher interest rates restrain spending and investment by reducing the availability of cheap money. This may lead to market disequilibrium where demand exceeds supply, triggering inflation.
This is why it is so important to understand the dynamics of different types of interest rates, including simple interest and compound interest. The more you understand how different types of interest work, the better you will be able to manage your own personal finances.