Interest rates are one of the most important economic factors that influence the personal finances of the average person. An interest rate is the cost of borrowing money. Banks and other lenders charge interest on the borrowed funds because lending involves the risk that the borrower will not pay and forgoing other opportunities such as investing the money. Interest rates have several important impacts on the individual and the overall economy.
Perhaps the most obvious impact of interest rates for the average person is that they determine how costly it is to borrow. When you apply for a loan, be it a mortgage for a new home, an auto loan or a student loan, the interest rate determines how expensive the loan will be to repay. High interest rates make borrowing more expensive and make debts more costly to repay. Debts with very high interest rates like credit cards can be difficult to ,which can lead to a cycle of paying down interest without paying back much of the original amount borrowed.
Interest rates also directly affect people who save money. Just like banks charge interest rates on borrowed funds, they pay interest to individuals who save; when you save at a bank, you are essentially giving the bank a loan. High interest rates mean higher savings rates at banks, which benefits savers and encourages saving. Since high interest rates benefit savers and hurt debtors, they tend to increase the disparity of wealth between people who have money and those who are in debt.
Savings and investment are two sides of the same coin. When you have extra money lying around, two of your options are to save it at a bank or invest it in something that might earn a larger return such as stocks or real estate. High interest rates make saving relatively more attractive, which can reduce investment and therefore reduce stock prices. On the other and, low interest rates tend to discourage saving and increase investment. The U.S. Federal Reserve often cuts the key interest rates it controls to spark economic activity and investment. When interest rates are low, people can borrow more easily and therefore spend more easily, which tends to generate economic activity.
Inflation is the rate at which prices increase in an economy. If prices rise increasingly quickly it reduces the impact of high interest rates. "Real interest rates" are interest rates calculated by subtracting the expected rate of inflation from nominal interest rates. For instance, an interest rate of 5 percent on a loan might seem high, but if inflation is expected to be 5 percent, the real interest rate would be zero.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.