Interest rates are an essential part of the financial system, affecting every person who borrows or invests. Understanding the basics of how interest rates work can help you make wiser financial decisions, whether you’re buying a home or using a credit card, saving for retirement or managing a business.
Interest is a fee paid by a borrower to a lender in exchange for the use of an asset. In the context of lending, the asset can be cash, consumer goods, vehicles, land, or even time. Interest is calculated as a percentage of the principal amount borrowed or lent, and is typically expressed per period, such as a year.
When interest rates are high, it becomes more expensive to borrow money, which can slow economic activity. On the other hand, when interest rates are low, it is cheaper to borrow, which can stimulate spending and investment, potentially leading to higher economic growth.
There are two common methods for calculating interest: simple and compound. Simple interest is calculated as a flat percentage of the principal sum, making it easy for borrowers to plan repayments. Compound interest, on the other hand, calculates the interest due over a longer period of time, adding new principal to the calculation each year. The majority of formal interest payment calculations today are compounded, and the calculator used in this article uses compounding. The distinction between these two types of interest is also sometimes referred to as nominal and real interest, although the latter takes into account inflation and bank fees to provide a more complete picture of the true return or cost of an investment or loan.
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