If you have ever borrowed money, you have probably heard of interest rates. Or better yet, if you are familiar with the Federal Reserve, you have probably heard the term. But what are they?
Interest rates are fees charged on borrowed money, usually expressed as a percentage of the loan amount. Mortgages, car loans, and credit cards are a few examples of loans where interest may be charged. Mortgages generally have lower interest rates than car loans and credit cards.
To better illustrate the concept of interest rates, let’s use an example. Borrower A gets a $100 loan from ABC Bank, payable in one year. In order to make money, ABC Bank will charge Borrower A a percentage of the loan in fees. ABC Bank sets the interest rate on the loan at 5%. After one year, Borrower A will repay the $100 loan PLUS $5 in interest ($100 X 5%).
The Federal Reserve is the United States’ central bank, responsible to promoting price stability and maximum employment. In order to achieve those two goals, the Federal Reserve will adjust interest rates to encourage or discourage economic activity.
Banks aren’t the only ones who make money off of interest rates…you can too! Most banks pay depositors interest on the balances in their savings accounts. For example, Depositor A deposits $1,000 into a savings account and XYZ Bank. At the end of every year, XYZ Bank will pay 1% on the balance in the account, resulting in a payment of $10.
Interest rates are an important concept in financial literacy. The quicker you understand them, the better positioned you will be to use them to your advantage!