Interest rates play a big role in your financial life, from the cost of borrowing money to the rewards you earn when saving. Understanding how they work can help you make better choices and save more.
When you borrow money, a lender or creditor charges you an interest rate to compensate for the risk of lending you the money. This charge is typically expressed as a percentage of the principal amount borrowed, and it is usually calculated over a period of one year (also known as an annual percent rate or APR). The same formulas are used to calculate the interest you earn when you save or invest money in deposits like certificates of deposit (CDs) and savings accounts. Interest rates may be fixed or they can change over time, depending on market conditions.
The Federal Reserve uses interest rates as a tool to manage economic growth and inflation. When interest rates are high, it’s more expensive to borrow money, and this slows down spending and investment. When interest rates are low, it’s easier to borrow and spend, which stimulates the economy.
Interest rates and bond prices have an inverse relationship, meaning that when interest rates rise, bond prices fall. This is because bonds with lower coupon rates issued in a higher-rate environment have to pay more in interest to attract investors. This can make existing bond holdings less attractive, but a well-diversified portfolio can cushion the impact of short-term changes in interest rates on investment returns.