Interest rates are critical to our personal and business finances. They determine how much it costs to borrow money, the growth of savings vehicles and even the profitability of some investments. Understanding how interest rates work can help you take control of your finances and plan for the future.
An interest rate is the percentage of a principal amount that a lender charges a borrower or earns from a depositor, expressed as a decimal number over a period of time, usually a year. Borrowers want low interest rates to pay less to borrow, while investors seek high interest rates for greater returns.
Lenders charge interest to cover their expenses and to make a profit. When a business has losses that reduce its equity, those losses are offset by the amount of the debt-to-equity ratio at the beginning of the loss period. The financial risk premium is the percentage of the loan that lenders add to account for this type of loss, and it is a component of the overall interest rate.
Interest rates are commonly quoted on an annual basis, and the resulting annual percentage rate (APR) is the metric that consumers use to compare loans. However, it’s important to look at the effective annual interest rate, which takes compounding into account. For example, a loan that compounds twice a year will have an effective interest rate higher than a loan that compounds once a year because it grows more quickly.