Interest rates play a key role in all of our financial decisions, from taking out loans to maximizing savings. But the differences between credit card rates, auto loans, mortgages and personal loans can be confusing. That’s why it’s important to understand how they work and the factors that affect them.
The term “interest rate” refers to the price charged for borrowing money or the fee earned for lending it, expressed as a percentage of the principal amount. It’s also the rate of return on investments like CDs and savings accounts. In monetary policy and macroeconomics, it’s sometimes called the discount rate, nominal interest rate, real interest rate, real economic profit, internal rate of return, or opportunity cost.
There are a variety of factors that influence interest rates, including the risk and opportunity costs associated with each type of debt or loan. For example, mortgages are secured by real estate and typically come with lower interest rates than unsecured personal loans or credit cards because lenders can take possession of the property to avoid losses if the borrower fails to pay. The duration of the loan or debt is another factor. Longer terms generally have higher rates because of the increased risk and opportunity costs involved.
Another key factor is the overall economy. When the economy is healthy, the Federal Reserve (the US central bank) can raise or lower mortgage and consumer interest rates to encourage growth or prevent recessions.