What are interest rates?

Start investing
Andrew Goldman

Andrew Goldman has been writing for over 20 years and investing for the past 10 years. He currently writes about personal finance and investing for Wealthsimple. Andrew's past work has been published in The New York Times Magazine, Bloomberg Businessweek, New York Magazine and Wired. Television appearances include NBC's Today show as well as Fox News. Andrew holds a Bachelor of Arts (English) from the University of Texas. He and his wife Robin live in Westport, Connecticut with their two boys and a Bedlington terrier. In his spare time, he hosts “The Originals" podcast.

Interest rates are how much banks will charge borrowers as well as how much they’ll pay to those who deposit money. It might be helpful to think of money you borrow as akin to a rental car; in the same way you have to eventually have to return the car, so too do you have to return the amount you borrowed from the bank — called the principal. The interest charged on the principal is a lot like the rate the rental car company charges you for the right to drive their super-boring-dog-hair-covered sedan. Interest rates — often expressed as APR, or Annual Percentage Rate — will depend on many factors: how good your credit history is, thus, how sure a bet you are to pay back your loan—and because of that, riskier folks are charged higher rates. Credit cards’ APRs are consistently higher than say, home mortgages, largely because of the administrative costs associated with running cards (and consumers’ shocking willingness to be saddled with insurmountable debt tomorrow in order to buy dope skis today.) Banks always pay lower interest rates on deposits than they charge on loans, because the sliver of percentage rate that divides the two rates is where the bank makes money.

A large factor affecting consumer loan rates is the Federal Funds Rate set by the Federal Reserve, the central bank of the United States. People mistakenly assume that there is a direct correlation between interest rates and rates set by the Fed; there’s an indirect link since the Federal Funds Rate is the interest rate that banks pay to access capital to pass along to borrowers. The Fed raises that rate to counteract inflation by limiting the supply of money circulating in the economy. When the spigot providing money to banks is turned down, and money to loan becomes scarcer. When money is scarcer, you’ll not only have a harder time getting a loan, you’ll be charged more to borrow if you do get one.

Last Updated January 29, 2018

Trade stocks commission-free

Start trading