Finance Guide

The term “interest rate” is used when discussing credit cards, car and home loans, and other forms of borrowing of money. Represented as a percentage, it refers to the fee the bank, credit card company, or other institution charges to lend money. For example, if you buy an MP3 player for $100 with a credit card, the credit card company pays the bill-in other words, it lends you $100-and charges you interest, or a fee, for that loan.

This fee, known as the interest rate, is a percentage of the amount borrowed. In the example of the MP3 player, the credit card company might charge an interest rate of 15 percent per year. If you paid the bill immediately, you would owe no interest. If you waited a year to pay the bill, you would be charged 15 percent of the $100 loan, or $15, raising the total amount owed to $115.

Charging interest is how banks and other lending institutions make money, and without it they would have no incentive to make loans. Lending money, in turn, is essential for the economy. It allows people to make necessary large purchases, such as cars and homes; to pay for college tuition; and to afford vacations and other desired nonessential purchases. Companies borrow money for a variety of reasons, such as buying manufacturing equipment, that help them start up, grow, and compete with other businesses. Even governments take out loans when they spend more money than they raise with taxes.

Consumers, businesses, and governments all pay an interest rate on their loans. Their desire or even ability to take out a loan will often be determined by the size of the interest rate. If an interest rate is low, such as 5 percent, a loan is much cheaper and much more desirable than if it were 20 percent. For example, when buying a house with a 30-year loan, a person might spend hundreds of thousands of dollars more on interest (over the 30-year period) if the rate were 20 percent as opposed to 5 percent.

Modern economies are greatly influenced by changes in interest rates. Generally speaking, when interest rates fall, three things happen: more loans are made, money from the loans (otherwise not available to people, businesses, and governments) is spent, and thus the economy grows more quickly. When interest rates rise, the reverse happens, and economic growth slows down.