Interest rates impact how much it costs to borrow money, how fast your savings grow and even the buying power of your money. Whether it’s on a credit card or mortgage, the interests charged by financial institutions can add up to thousands of dollars over time. The rates high street banks set depend on more than just the Bank Rate and can be based on how risky they think it is to lend money or invest in their customers.
The simplest definition of an interest rate is the fee (or rent) paid or earned for the use of another person’s assets. In lending or investment, this fee is a proportion of the amount lent, deposited or borrowed, and is usually measured as a percentage over a period that’s typically one year but can be any length.
Lenders may charge a higher interest rate if they believe there is a greater risk that the loan will not be repaid, or if they are concerned that their investments will decline over time (known as “compound interest”). These are known as financial risks and can be calculated based on the ratio of debt-to-assets and the equity buffer of the business entity.
Investors may also earn an interest rate on investments, such as bonds, based on the risk level they are willing to take, how long their investing timeline is and the liquidity preference of investors (how quickly they want to have their funds available in liquid form). These are known as market risks.