If you've ever opened a savings account or borrowed money — or you just follow the news — you've likely heard all about interest. It's clear interest is important: it affects the national and even global economy, and impacts consumers worldwide.
What's less obvious is what interest actually is, how it works, and how different interest rates affect you. We have answers. Read on to learn interest rate definitions, and how interest rates impact your wallet when you save or borrow money.
What Is an Interest Rate?
Simply put, interest is the cost of borrowing money — kind of like a “rental fee" for borrowing. An interest rate is how much interest you'll pay, and it's usually expressed as a percent of the amount borrowed.
As a consumer, there are two general types of interest rates you need to understand. There's the interest rate you pay when you borrow money — for example, taking out a loan — which is called the annual percentage rate, or APR. And there's the interest rate you earn from depositing your money into a bank account, which is called the annual percentage yield, or APY[1].
What Is the Annual Percentage Rate?
APR is the interest rate you'll pay when you borrow money. The rate may be variable or fixed. A variable interest rate will increase or decrease as market interest rates change. A fixed rate will remain the same no matter how market interest rates may fluctuate.
What is the annual percentage yield?
APY is the interest rate you'll earn when you store money at a financial institution — for example, in a savings account. Because the bank has effectively borrowed your money, even though it's still available for you to withdraw, it will pay you interest.
What Determines Interest Rates?
One of the factors that affect interest rates is the federal funds rate, which is the rate banks charge each other for loans. This is set by the Federal Reserve, or “the Fed," which is an independent government agency and the central banking system in the United States.[2]
When you hear that the Fed has decided to raise or lower interest rates, it means they changed that federal funds rate. The Fed can help regulate the state of the economy by either raising or lowering rates.
For example, the Fed may raise interest rates when the economy is booming, making borrowing money more difficult in an effort to prevent inflation. However, if the economy is slow, the Fed may lower rates to encourage borrowing and spending to spur more economic activity[3].
How Do Interest Rates Affect Consumers?
Whether you're borrowing or earning money, the federal funds rate can impact the interest you'll earn or pay.
Taking out a loan when federal interest rates are high generally means you'll need to pay more interest than if you took out the loan when rates were low. And if you have a loan with a variable interest rate, you might see an increase in your monthly payment. On the other hand, borrowing when rates are low generally means you'll pay less interest. After all, the Fed lowers rates to encourage borrowing, so borrowing becomes cheaper[3].
If you're a saver with a savings account or Certificate of Deposit (CD), changes in the federal fund rate affect you, too. Higher federal fund rates may raise your APY, so you'll earn slightly more interest from your savings than you did when rates were low[4]. When rates are low, though, you'll earn less interest on your savings. However, the changes tend to be subtle, so don't expect major shifts in your savings when the Fed changes interest rates.
Still have questions about how interest rates might impact your plans to save or borrow money? Visit our Interest Rate Center, which has region-specific information to help you make more informed financial choices.
