One form of interest familiar to most of us is on our credit card purchases. We are charged a monthly interest rate on our unpaid balances. If you spend $100, you will be charged interest each month for the portion of the original loan remaining. If you pay $20 on the loan in the first month, you will reduce the loan to $80. The next month, however, you will have to repay $80 plus the monthly interest.
The Federal Reserve Bank sets the interest rates. These are raised when the economy is heating up. This has the affect of decreasing consumer spending by adding greater interest to financed purchases. When the economy begins to slow down, interest rates may be lowered by the Federal Reserve Bank to increase consumer spending. With lowered rates, consumers tend to use their credit cards more often and finance more purchases of major appliances and cars.
Interest rates vary. You may have a fixed rate of interest. This where the lender sets the rate of interest when the loan is made. The rate never changes over the length of the loan. If you borrow, $100, you agree to repay $100 plus interest, 10% for example, over a fixed period of time. The total amount of the loan would then be $100 plus 10% interest or $110.
There are also variable interest rates. Here you agree to repay a loan, but the interest rate is subject to change and the amount of interest is calculated on the monthly balance. If you borrow the same $100, you will owe $100 the first month. You pay $10. In the next month you will owe the remaining amount of the bill, $90, plus the interest for that month, 10% for example. In effect, you will now owe $99, despite the fact that you have paid $10 against your loan. If you repeat your payment of $10 the following month, you will now owe $89 plus 10% or $97.9. You can see that after paying $20 on your loan, you have only lowered the amount by $2.10. This is why you should not keep high balances in variable rate accounts.
The lender sets the rates for your loan. This is because he/she sees you as a risk. Interest rates depend on your credit history. If you have good credit, the interest may be lowered. If you have bad credit, then the risk is greater and your interest rate is going to be higher. Lenders can quickly learn your credit history by looking at your credit report.
The length of the loan affects your interest. Financial institutions are likely to offer you lower interest rates if you obtain a loan with a longer repayment time. Instead of repaying your $100 plus 10% over one year ($110), the bank might give you an interest rate of 8% over two years, costing you $116. While $6 interest may not seem like much, you can imagine what the interest would be if the loan was for $1,000 or $100,000.
There is also interest paid on investments. One of the most common forms of investment is a savings account. Here interest is calculated on the amount of money you invest and how long you leave it untouched. If, instead of borrowing $100, you put it into a savings account and left it there for one year, you will have $100 plus the banks interest rate. If the bank paid 5% interest, you would have $105 at the end of the year. If you left the money in the bank for another year, you would have $105 plus 5% interest or $110.25. The more money you place into a savings account, the greater the amount of interest the bank will have to pay you.