Interest Rate Explained in Details

There are various ways interest rates are understood. In its simplest form, an interest rate is the percentage of the principal (as the original loan amount is commonly called) charged over a designated period of time, typically a year. In the case of the MP3 player, the interest rate is 15 percent per year.

The real interest rate takes into account the yearly inflation rate (that is, the average percentage increase in the price of all goods and services in the economy). If the average price increase, or inflation, for the year were 3 percent (thus reducing the purchasing power of your money by the same amount), the real interest rate would, in the example, be 15 percent minus 3 percent, as the $115 owed to the credit card company would be worth 3 percent less than when the purchase was made.

Another common term is compound interest. Without compound interest, a $100 loan with a 15 percent interest rate would result in the following amounts due, assuming you made no payments: $115 after the first year, $130 after the second, $145 after the third. In other words, each year the company would charge you 15 percent of the principal. Instead, banks, credit card companies, and other institutions charge compound interest. The first year would be 15 percent of the $100 loan, increasing the amount due to $115; the second year would be 15 percent of $115, boosting the loan amount to $132.25; and for the third year, the amount owed would be $152.09. Each year you would pay interest, or a percentage fee, not only on the principal but also on the interest from the previous year, thus creating "compound" interest. For credit cards, payments are due each month, and the annual interest rate (15 percent in the example) is really a compound interest of 12 monthly interest rates.

Interest rates are also used in such financial services as savings accounts and CDs. CDs, or certificates of deposits, are similar to savings accounts but do not allow any withdrawals for a designated period of time, such as one year. Consumers and businesses open savings accounts and CDs to earn interest on their deposits. If you deposit $100 in a savings account or CD that offers an interest rate of 5 percent, you will have $105 in that account after a year. In this way, consumers and businesses receive interest because they "lend" money to the bank.

Bonds, another form of borrowing money, use interest as well. In order to raise money, governments and corporations sell bonds, which are essentially certificates that promise that the government or corporation will repay the price of the bond, plus interest, after a designated amount of time, such as five years. Government bonds are often called securities. The U.S. government, for example, sells securities to pay for the national debt (when the government spends more than it collects in taxes, there is a debt, which the government must pay). Local governments commonly sell bonds to pay for large-scale projects, such as schools, swimming pools, and jails.

The exact interest rate of a loan-5.2 percent or 23.5 percent, for example-is largely determined by the market forces of supply and demand and thus is beyond the control of any individual person or institution, such as a bank. When looking for a home loan, or mortgage, a consumer can go from bank to bank to find the best price, thus encouraging banks to compete with each other in offering the lowest possible interest rates. But because interest pays for a bank's operating costs-and because inflation (rising prices in the economy) reduces the value of money each year-there is a limit to how low an interest rate can be.

Governments, however, have significant influence over interest rates and inflation, notably through their central banks (in the United States, the Federal Reserve), which try to manipulate rates by increasing or reducing the supply of money. Other factors, such as the size of the government's national debt, also have the potential to affect interest rates. When the national debt rises, the government pays for it by borrowing money, in some cases increasing the demand, and thus the price (or interest rate), for the limited supply of money available for loans.

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