Interest rates represent the cost of borrowing money or the return earned on savings and investments. When you borrow, the interest is what you pay; when you save or invest, interest is what you earn.
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1. Why Interest Exists
Interest is charged because the lender gives up access to their money for a period of time. The interest compensates them for:
- The risk of not being repaid.
- The loss of potential use of that money elsewhere.
2. How Interest Is Calculated
Simple Interest
Calculated only on the original amount.Simple Interest=Principal×Rate×Time\text{Simple Interest} = \text{Principal} \times \text{Rate} \times \text{Time}Simple Interest=Principal×Rate×Time
Example:
You borrow $1,000 at 5% per year for 1 year → You pay $50 interest.
Compound Interest
Interest is calculated on the original amount plus previously added interest.
This causes money to grow faster.Compound Interest=Principal×(1+Rate)Time\text{Compound Interest} = \text{Principal} \times (1 + \text{Rate})^{\text{Time}}Compound Interest=Principal×(1+Rate)Time
Example:
$1,000 at 5% compounded yearly for 3 years → Grows to $1,157.63
3. Types of Interest Rates
| Type | Meaning |
|---|---|
| Fixed Rate | Stays the same throughout the loan period. |
| Variable Rate | Changes over time based on market conditions. |
| Nominal Rate | Stated rate, not including compounding. |
| Real Rate | Nominal rate adjusted for inflation. |
4. What Affects Interest Rates
Interest rates are influenced by:
- Central Bank policies (e.g., Federal Reserve).
- Inflation (higher inflation → higher interest rates).
- Supply and demand for loans.
- Economic conditions.
5. Why Interest Rates Matter
- For Borrowers: Higher interest increases the cost of loans (e.g., mortgages, car loans, credit cards).
- For Savers: Higher interest increases returns on savings accounts and investments.
- For the Economy: Low interest rates can encourage spending; high rates can slow it down.
Summary
Interest rates determine how expensive it is to borrow money and how much you earn when saving. Understanding them helps in making better financial decisions regarding loans, investing, and saving.
