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How Do Interest Rates Work?
By: Max Plata
One of the most confusing things about borrowing money is calculating the
interest rates. Interest rates vary and when you go to take out a loan or a
mortgage it might seem intimidating when the loan officer starts talking about
interest rates per annum, nominal rates and market interest rates.
There are different types of interest rates depending on whether you are
borrowing money or investing money.
When you are borrowing money you have to pay interest back at a set rate. These
rates are determined by several factors. One of these factors is risk. If you
have a bad credit rating the rates at which you pay interest on loans may be
significantly higher than someone who has a pristine credit rating.
The reason for this is that the lender sees you as a risk. When you are a risk,
the rates applied to your lending rise. This can make it especially difficult
for someone with a bad credit rating to purchase anything major including a home
or a vehicle. They may be able to afford the initial payments, but once the
interest rates are added, the amount exceeds their budget.
Another factor that determines interest rates is the length of the loan. Lower
interest rates are often offered if the consumer extends the period of the loan.
To the consumer this may seem like a windfall. They view the smaller interest
rates as a savings to them. Short term it is but since the loan is being
extended to take advantage of the lower interest rates, they are actually paying
out more money in interest over the length of the loan.
Interest rates do not only affect just the consumer but they have an impact on
the economy as a whole as well. When interest rates climb, people are less
likely to purchase goods that aren’t essential to their lives. Car sales drop
and home sales often plummet as well. The average consumer doesn’t want to spend
the extra money on the increased interest because the rise in rate just means
less money in their pocket. The cost of the goods they are purchasing hasn’t
changed, it’s the cost of purchasing those goods that has.
On the other side of the interest rates spectrum is investing. People want to
invest when interest rates are high so as to yield the biggest profit. Years ago
the traditional savings account was often viewed as the traditional investment
tool. The bank would post their interest rates and people would save their money
in the hopes that it would grow substantially over the course of a number of
years.
Today you are more apt to find people investing in many diversified things;
money market funds, the stock market and bonds. If you decide to invest in bonds
they will have a posted interest rate. The rates on bonds might be slightly
higher than other investments because with many bonds you have to lock your
money in to the investment for a specific amount of time. The period can be
anywhere from several months to several years.
Interest rates impact our lives everyday whether we are aware of them or not. To
keep on top of both your borrowing and investment needs it’s a good idea to
follow interest rates.
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