Interest rates are a critical part of your financial life, determining how much it costs to borrow money and the return you earn on investments. Understanding how these rates work can help you manage your debt, make wise investment choices and plan for the future.
Interest is a charge for the use of an asset, including cash, property and consumer goods, and is typically calculated as a percentage of the amount borrowed or lent over a period of time, usually a year. There are two types of interest: simple and compound.
When a lender offers you a loan, the interest rate will be determined by several factors, including the security of the assets offered as collateral, taxes and the creditworthiness of the borrower. In addition, the lender’s risk tolerance can impact the interest rates it offers. Mortgage loans, for example, are secured by a home or other real estate, which reduces the risk to the lender and can be used to cover losses if you fail to pay back the loan. This makes mortgage loans generally offer lower rates than personal or credit card debt that isn’t secured by assets.
Interest rates are also impacted by the state of the economy. For instance, if the Federal Reserve becomes concerned about inflation or over-exuberant economic growth, it may raise interest rates to slow down the economy. This can cause people to spend less and invest less, which reduces the supply of capital that businesses need to expand and grow their business.
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