What are interest rates? The basics explained
Learn the ins and outs of interest rates so you can make smart decisions on your savings, credit cards, and loans. You’ll discover what interest rates are, how they change, and why they matter for your financial choices. It’s also a useful thing to understand when picking out a savings account.
Interest rates definition
An interest rate is the amount a lender charges someone to borrow money—or any asset really. Banks can also offer interest rates on your savings, to encourage you to bank with them and help you grow your money.
Imagine you’d like to borrow some money. The person lending you that money might charge a percentage of the amount you borrow. It’s sort of like a rental charge, as you would pay to rent a car or property. That percentage is the interest rate, often called an annual percentage rate or APR.
How do interest rates work?
Whether you’re looking to open a savings account or take out a credit card, interest rates work the same in both instances. There are two ways the interest rate is agreed upon—as a fixed or variable rate. Fixed interest rates stay the same throughout the agreement. A variable interest rate will rise or fall with the ‘prime rate’—the one set by centralized banks.
The two types of interest to know about are ‘simple interest’ and ‘compound interest’.
Simple interest
Simple interest is based on the principal amount—that is, the original amount of money being loaned or deposited into a savings account. Simple interest is often applied to car loans, short-term loans, and sometimes mortgages. To calculate how much you could end up paying for a loan with simple interest, you can simply multiply the principal amount by the daily interest rate and the number of days until the end of your loan period.
Compound interest
Compound interest is based on the principal amount, plus any interest raised during an agreed period. This means you’ll be paying interest on interest. The amount owed will grow quicker than if it were simple interest. You often see compound interest applied to credit cards. It’s best to pay the interest of each compounding period—the time between each time interest is compounded—in full when possible, to avoid the amount you owe from growing quickly.
How are interest rates applied?
Interest rates mostly apply in situations where somebody borrows money. It’s up to the organization lending the money to decide whether they’ll charge interest or not.
Interest can be applied to other things too, like bank interest rates on savings accounts. Lots of savings accounts offer interest on the money that you deposit. The higher the bank interest rate, the more you’ll earn on your savings.
Discover more tips on how to save money
When do interest rates go down?
Supply and demand play a big role in the ups and downs of interest rates. Take the recent pandemic as a prime example—with so much uncertainty, people and businesses were hesitant to borrow money, so interest rates fell. Low economic growth and inflation rates can drive down interest rates. Interest rates may also fall lower when banks have more money to lend or invest—as this increases supply, your savings will make less money due to lower interest rates, but the cost of borrowing goes down.
When will interest rates go up?
Interest rates are always changing. So if you’re considering a loan, it’s good to keep an eye on how interest rates are fluctuating. When the economy is experiencing growth and inflation, any money lent by banks today is worth less tomorrow. This is because the value of money decreases when inflation occurs, like how a carton of milk costs much more than it did 10 years ago. In this situation, banks are likely to increase interest rates to counteract their losses over time.
What are negative interest rates?
Occasionally you might see an interest rate written as a negative percentage, like ‘-2%’. This is called a negative interest rate. It’s where a lender is actually paying the borrower to take out a loan, or a bank is charging a customer to keep their money in a savings account. It may sound counter-intuitive, but in extreme economic situations, central banks do this to encourage spending and taking out loans. It’s often done in response to extreme deflation.
Why do lenders charge interest rates?
Organizations charge interest rates on loans to compensate themselves for not being able to use that amount of money for something else. For example, if the lender had invested the money elsewhere, it could have grown in value. So, by charging interest, they are still making that money generate value and grow. The lender also takes on the risk of the borrower not being able to pay back the loan, known as ‘defaulting’. Charging interest helps the lender to counter the risk of defaulting.
Why do banks offer interest rates on savings?
Banks pay interest on savings to encourage people to deposit their money. In turn, the bank can then invest and grow the deposited amount. Having lots of savings deposited in a bank also increases the amount that the bank can offer as loans to their customers. When choosing a savings account, look for deposit protection—this will protect your money even if a bank were to go bankrupt. At N26, your money is protected up to €100,000, thanks to the German Deposit Protection Scheme.
What are interest rates today?
Interest rates are changing all the time and they will vary depending on what country you are in. If your country has a centralized bank, they will decide the rates on short-term loans. For example, in Europe, benchmark interest rates are set by the European Central Bank (ECB). You can find resources online that show the current interest rates in the world’s biggest markets.
How long will interest rates stay low?
Calculating interest rates is a complicated task. Economists are always trying to predict when interest rates might rise or fall, but the truth is, there are so many factors to consider that they can’t know for sure. Interest rates in most developed countries have stayed low in recent years. To catch signs that they might change, keep an eye on inflation, employment rates, growth forecasts, and adjustments from centralized banks. Increases in these factors can result in higher interest rates.
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What are interest rates?
An interest rate can be an amount that you earn for keeping your money in a savings account, or a charge you pay for borrowing money or assets. When it comes to borrowing money, prime examples are for a mortgage, a credit card, or a personal loan. You’ll see an interest rate written as a percentage—and that’s because interest rates are calculated as a percentage of the original amount that you borrowed or deposited into a savings account. When it comes to simple interest, you’ll pay a percentage of the original amount borrowed. For compound interest, you’ll pay interest on the original loan, plus any interest that’s been added for a certain time period. Bank interest rates are the amount the bank will award you for keeping your savings in savings accounts.
What do APR and APY mean?
APR stands for annual percentage rate. This is the interest rate that’s charged on a loan, and can be seen as the price you pay to borrow money. You’ll often see it when people talk about credit cards, or for taking out loans. APY stands for annual percentage yield. This is what you’re more likely to see when you open a savings account at a bank. It’s the amount you’ll earn by keeping your money in a savings account.
What are negative interest rates?
Negative interest rates are when an organization pays borrowers to take out loans or borrow assets. It can also result in savers having to pay a bank to keep their money in their account. It may sound extreme, but sometimes governments or central banks set negative interest rates to encourage spending during periods of recession, when the economy is decreasing. Negative interest rates will show as a negative percentage, for example, -2.5%.
How are interest rates set?
The supply and demand of credit, inflation, and economic growth or uncertainty all play key roles in setting interest rates. They usually rise with inflation, where the value of money decreases. If inflation increases, it means the money lent by a bank today has less value tomorrow, so interest rates can increase to cover this loss for the bank. If the supply of credit increases, such as when banks have lots of money they can lend or invest, this will bring interest rates down.
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