The interest rate is a crucial factor in borrowing and saving, shaping the financial landscape and impacting the overall economy. Understanding how it works, who sets it and its relationship to inflation is essential for individuals managing their finances.
Historically, most countries have had positive rates of interest, or returns on savings and investments that exceed the rate of inflation. But today’s low and even negative interest rates have created a complex and challenging environment. The reasons are varied and complex, ranging from long-term demographic trends (especially in advanced economies), weak productivity growth, the shortage of safe assets and even declining inflation expectations.
Borrowing and Saving
When interest rates rise, it becomes more expensive to borrow money. People and businesses may reduce spending and investment, leading to slow economic growth or even a recession. This can lead to reduced stock prices, which can further push up borrowing costs. Rising rates also give financial institutions more room to offer competitive interest rates on savings accounts and GICs, making these investments more attractive.
Different types of loans come with different risk profiles, which influences the interest rates they’re charged. For example, mortgages typically have lower interest rates than personal loans or credit cards, because they are secured by the collateral of the home. In addition, the duration of a loan and whether it’s a fixed or variable rate can affect its interest rate.
Ultimately, it’s the effective rate that borrowers pay (the APY or annual percentage yield) that matters. This takes into account compounding and other fees, which can vary from the nominal or stated interest rate. For example, a payday loan of $100 with repayment due in 2 weeks will have an APR of around 400%, because it will include a $15 fee in addition to the original $100 borrowed.
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