TheStreet

In the world of finance, the interest rate plays a huge role on both sides of a deal, and with big ramifications for both parties. Learning all you can about interest rates and how they work can give you a leg up in a financial deal, whether you're the one extending the money or you're the one borrowing it.

  • For the borrower, the interest rate is the price he or she pays for the use of money, as in a loan or as a price for credit.
  • For the lender, the interest rate is the "fee" earned for taking the risk to extend credit or to loan money to a borrower.
  • For the saver and investor, the interest rate represents the return on investment for a bank savings account or an investment in a fixed income vehicle, like a U.S. Treasury Bond.

In contrast, if you don't know enough about interest rates, your deal outcomes could turn negative, as you leave too much money on the table, when you could have struck a better deal.

Here's the skinny on interest rates, and why they matter so much in the world of finance.

What Are Interest Rates?

Basically, an interest rate is the amount of money a lender or creditor charges for access to money.

The principal is the amount of a loan or total credit extended (like on a credit card.) The interest rate is what a lender charges a borrower, as expressed in annual percentages. For instance, an auto dealer will extend financing to a customer buying a new car. For access to that financing, the vehicle buyer will pay interest on the auto loan, so he or she doesn't have to pay the entire cost of the car upfront.

Interest rates take on other forms, too.

For investors (think bond and bank savings investors), an interest rate is what a bank or bond issuer will pay investors or savers, for access to their money. For example, a bank will pay a small interest rate to get a consumer to keep his or her money in a bank account.

Interest Rates and APR

The terms "interest rate" and "annual percentage rate" are often misunderstood by borrowers, who believe they have the same meaning. While both terms come from the same interest-related financial family, there is a difference.

  • An interest rate is the rate beyond the principal a borrower pays to gain access to money, for financial tools like credit cards and mortgage and auto loans.
  • The annual percentage rate is the annual cost of a loan or credit, including any fees or additional costs attached to a loan or credit deal. For example, a mortgage loan can include extra fees like discount points, mortgage insurance, loan origination fees, and broker fees.

Who Determines Interest Rates?

Interest rates are based on three key financial and economic factors, as follows:

  • The Federal Reserve. The Federal Reserve issues the benchmark fed funds rate, the short-term interest rate that banks and other depository financial institutions charge each other to borrow money, on an overnight basis.
  • U.S. Treasury notes and bonds. In the fixed-income investment market, demand for U.S. Treasury notes and bills impacts longer-term and fixed interest rates on loans and credit.
  • The banking sector. Banks are in a competitive business environment, and must hit the sweet spot between making a decent rate of return on loans and deposits and keeping rates attractive enough to earn the business of deposit holder and borrowers. Consequently, bank savings rates and bank loan rates operate in close range across the entire industry, thus giving financial institutions, borrowers and investors a good idea of where interest rates are at a given time, across a wide spectrum of rate areas.

Of the three influencers, the Federal Reserve has the largest impact on interest rates.

The Federal Reserve is tasked by the federal government to hold rates at a level where prices are stable and there is plenty of liquidity available in the U.S. economy. The Fed monitors the economy every day, and sets rates at a level where the U.S. money supply is in balance - not too large and not too small - to keep the economy stable and inflation at bay.

Within the Federal Reserve, the Fed's Open Markets Committee establishes U.S. interest rates on an ongoing basis. The committee is comprised of seven Federal Reserve Board governors and five Federal Reserve Bank presidents. The committee meets eight times annually, where U.S. monetary policy and interest rate levels are studied closely, and where interest rates may be adjusted as economic conditions warrant.

It's worth noting that there are other factors that impact the direction of interest rates.

For example, companies review a borrower's credit report to evaluate whether to extend money or credit, and if so, the interest rate the company will charge to do so. Based on the applicant's credit score, lenders may charge a lower interest rate (for borrowers who have high credit scores, and are a better repayment risk) or a higher interest rate (for borrowers who have lower credit scores and are a larger repayment risk.)

How Do Interest Rates Work?

Interest rates are something of a sweet science for economists, and for financial institutions who lend money and extend credit.

The goal is to issue interest rates in that proverbial sweet spot, where the rate is high enough for lenders to make money but low enough to attract borrowers. In the case of a bank or bond issuer, the idea is to keep rates low enough to save money, but high enough to attract depositors and investors.

Let's take the case of a borrower who wants to buy a home, and is willing to pay interest on a home loan to seal the mortgage deal.

In this instance, the home costs $300,000, and the homeowner has $30,000 (10% of the home cost) for a down payment, leaving $270,000 needed to buy the home. Here, the formula for calculating the mortgage interest rate is fairly basic - principal times interest rate, times the number of mortgage payment periods (example = 30 years.)

Using that calculus, and including cost factors like property tax ($2,400 per year), PMI (0.5%) and homeowner's insurance ($1,000), and using a home mortgage interest rate of 4.25%, the homeowner will pay a monthly mortgage rate of $1,724.07, and pay total interest of $208,165.57 over the 30-year term of the mortgage loan.

Compound vs. Simple Interest

Interest can be calculated mainly in two models - as simple interest and as compound interest.

  • Simple interest can be calculated as a percentage of a loan (Simple Interest = principal x annual interest rate x years.) Simple interest is usually described as the interest a deposit holder or bond investor earns on his or her financial investment.
  • Compound interest differs from simple interest in that it is calculated (usually) on a monthly basis, base on the entire balance of a loan (including previous interest payments) or a savings or bond investment account (Compound Interest = principal x (1 + interest rate) years.)

A borrower will pay compound interest on things like mortgage loans and auto loans (which are repaid over an agreed-upon time period), and credit cards, too (which compound indefinitely, so it's advisable for card users to pay down their card debt quickly.)

On the savings and investing side of the compound interest equation, investors and savers earn compound interest based on the size of their total investment.

How Interest Rates Impact the Economy

Interest rates can influence the economy in multiple ways, but at a base, direct level, the biggest impactors are rising and falling interest rates.

Let's take a look at both scenarios:

Rising rates. Rising interest rates make the cost of borrowing money and getting credit tougher to obtain. That not only hurts consumers and businesses, who can't get the cash they need to buy a home or hire new employees, but it also hurts financial institutions, too. After all, with rates high and conditions dour on the lending front, that leads to fewer borrowers and fewer revenues and profits for banks, credit card firms, and other financial services companies. It also means less business for retailers, as customers make fewer purchases on goods like clothes and cars, thus hurting the bottom lines of U.S. companies, too.

On the plus side, bank depositors will see better returns in a rising interest rate environment, as will bond investors, who benefit when rates climb.

Declining rates. Lower interest rates lead to a multitude of financial problems and benefits for consumers, companies, and financial services firms. In a lower rate environment, consumers and businesses often slow down savings, and increase their debt levels, as loans and credit are easier to obtain. Weaker rate levels also spell bad news for bank savers and bond investors, and investment returns fall as rates decline.

On the plus side, lower interest rates mean more opportunities to buy big-ticket items like homes and autos, which is good for the overall economy. Plus, stock market investors usually do better as rates decline and the economy improves, as companies make more seals and earn more profits, which are good for their bottom lines, and good for stock prices.