Interest is what you pay to borrow money or the payment that is made to you for the lending of your money. The amount of interest that you pay is computed as a percentage of the principal amount borrowed. This percentage rate can range from zero up to the maximum rate allowed by law in a particular locale.
Setting Interest Rates
Determining how much interest to charge or pay is very complex. In a simple example of the decision, a bank has $100 and must decide whether to loan it or invest it. If invested, another bank will pay 2% interest on the money for privilege of holding it. If the bank decides to loan the money instead, the interest rate it charges its customers must exceed what it can earn elsewhere, and compensate for the risk that the money may not be repaid. In reality, hundreds of other factors go into determining interest rates and they vary by the type of transaction, whether it is a home loan, car loan or interest on a credit card.
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Interest rates are often controlled at the highest level by government economists. Gauging economic activity, political concerns, and opportunity cost, the economists will recommend a baseline rate to the central banking authority. Low interest rates are favorable, as they spur borrowing but hurt savers and investors. High interest rates are good for savers but bad for borrowers who respond by tightening their purse strings.
Managing Interest Rates
The individual lending institutions ultimately establish the interest rates on their financial products. A baseline rate that is used to determine the institution's cost of money is the prime rate. This is a percentage rate determined by adding points to the federal funds rate, the interest rates banks charge one another for overnight loans. The money manager will also factor in the risk of making the loan, the length of the term of the loan and the collateral that secures the funds before setting a rate.
Maximum Interest Rate
Usury laws protect the borrower from being charged exorbitant interest rates. The maximum rate of interest that can be legally charged to a borrower is set by local law. Borrowers who present a high risk are charged high rates, some coming close to the maximum allowable rate. The laws do not affect the rate charged between private parties.
Types of Interest
The interest rate is also affected by the way in which it is accumulated. Simple interest is figured by applying the rate to the total amount borrowed or the unpaid balance of the principle. Compound interest is computed at set intervals—weekly, annually, or even daily—and the unpaid interest is added to the principle to establish a new balance. The interest due is figured on the new accumulated sum. A lender will take into account the type of interest calculation used when setting the borrower's rate.
Managing Your Interest Rates
The lowest interest rates are charged to the highest-quality borrowers. You can affect the rates you receive by keeping your debts under control and paying your bills on time. Your credit score has a large bearing on the rates you will be offered so it is important to conduct an annual review of the notations on the credit report behind the score.