When interest rates rise, it can boost profits for banks and credit unions that lend to borrowers. It can also help consumers save more and benefit companies that are able to better allocate capital across the economy.
But what exactly are interest rates, and how do they work? Read on to learn more about this basic financial concept.
Generally speaking, interest rates are charges on loans and debts that are repaid either in one lump sum or in periodic payments. Individuals borrow money to purchase homes, cars and other assets, fund projects and start or grow businesses. Businesses often borrow to expand by purchasing fixed and long-term assets like land, buildings and machinery.
While lower rates can encourage borrowing and growth, higher rates discourage it by making it more expensive for households and businesses to borrow. They can also dampen consumer spending, slow the growth of the overall economy and lead to inflation. In order to manage these effects, central bank policymakers on the Federal Reserve Board adjust interest rates in an effort to meet Congress’ mandate of promoting maximum employment and stable prices.
Investors should keep in mind that while a lower nominal interest rate is desirable, it’s the total amount of interest paid that’s important when shopping and comparing loan products. This is because fees can be packaged into the cost of borrowing, such as administrative fees for car-buying and application fees for mortgages. That’s why it’s best to focus on annual percentage rates, or APRs, rather than on nominal interest rates alone.