Borrowed money incurs interest, giving creditors incentive for lending. The amount of interest owed to lenders fluctuates, reflected in interest rates. How does interest work, and who determines US interest rates? Here’s what you need to know.
Interest rate definition
An interest rate represents the cost of borrowing money, or the payment due to a lender for the service of acquiring that money. Rates change depending not only on lender thresholds, but also the creditworthiness of the borrower. Interest is calculated using a percentage of the deposit or loan balance.
In most cases, this is quoted as an annual rate and interest repayments are paid periodically throughout the year to the lender. The result is that you’ll not only pay the original loan balance back to the lender, but also an extra payment on top of this, in the form of interest.
In a wider sense, US interest rates are vital to a functional economy by encouraging borrowing and spending. When bank interest rates are low, consumers are more likely to borrow and put this back into the market.
Who sets US interest rates?
Now that you know the interest rate definition, it’s helpful to learn who sets them. Short-term US interest rates are determined by the central banking system. The Federal Open Market Committee includes seven members of the Federal Reserve Board, along with five Federal Reserve Bank presidents. This powerful committee sits down eight times a year to set the country’s interest rates, influenced by current economic conditions. The idea is to set a base interest rate that encourages stable pricing, without veering into deflationary or inflationary prices.
The US Treasury Department is also key in setting interest rates by sparking demand for long-term Treasury notes. Lower demand for Treasury notes leads to higher interest rates, while high demand leads to low interest rates. Long-term interest rates are important because they impact the rate you’ll pay on things like a fixed-rate mortgage, auto loan, or long-term consumer credit product.
Individual factors that impact interest rates
While the Federal Reserve and US Treasury hold sway over market rates, the interest rate you can expect to pay will also depend on your credit history and the bank’s own policies. If you are taking out a personal loan or mortgage, bank interest rates will differ from the Fed’s baseline. The higher risk you are as a borrower, the higher the interest rate. Lower bank interest rates are available for borrowers under the following circumstances:
High credit scores
How does interest work?
There are a few different methods you can use to calculate interest, depending on whether you’re a borrower or a lender.
Borrowers repay more than the initial deposit or loan amount.
Lenders earn interest on the amount deposited or loaned.
The amount paid or earned in interest will depend on:
The initial deposit or loan amount
The interest rate
The repayment terms
Higher rates and longer-term lengths both lead to higher interest. It’s easy to plug these into an interest rate formula to see how it works in action.
Interest rate formula:
A = P(1 + rt)
A is the final value
P is the principal amount of money invested
R is the interest rate
T is the number of time periods
As a quick example, imagine that you’ve invested an initial amount of $100 at an interest rate of 4% per year, converted to a decimal of 0.04. Plugging this into the interest rate formula:
A = 100(1 + 0.04)
You would earn $4 over the course of one year, for a total balance of $104.
This is an example of simple interest, but many banks use compound interest instead. This results in higher yields over time by calculating the interest each day to grow the balance each time. In other words, you’re earning interest on top of interest.
Whether you’re taking on new debt or investing your money, keep interest in mind. Interest rates are a powerful tool and should take a front seat in any financial decision-making process.
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