How Interest Rates Work

Credit cards have a higher interest rate than mortgages. See more debt pictures.
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A letter arrives in the mail from your credit card company. Because of a significant change in your credit score, they're raising the interest rate on your credit card to 23 percent. What?

You're watching CNN and they're talking about a recent announcement from Federal Reserve chairman Ben Bernanke, in which he hinted that the Fed would be raising interest rates by a quarter-point in the next week. The stock market plummets, losing 357 points in one day. Why?

You want to save money to buy a motorcycle, so you invest in a five-year CD at the local bank with an interest rate of five percent. But when the CD matures, you notice that the price of motorcycles has gone up by three percent. You really only made two percent interest on that CD. What's going on here?

Before you get all worked up, you should know that interest rates aren't evil. They're the price of living in a world that relies heavily on credit and debt. If interest rates didn't exist, lenders would have no reason to let you borrow money. And if you couldn't borrow money, you could never pay for college, buy a house or a car, or enjoy many of the other advantages of life with credit, like ordering movies and books online with a credit card.

The National Debt Clock at 1133 Avenue of the Americas and 44th Street, in Midtown Manhattan, New York, shows the total US government debt (top) and the calculated amount per US family as of March 26, 2006.

In this HowStuffWorks article, we'll help you understand why interest rates exist, how they're calculated and why they change over time. We'll also explain what the Federal Reserve is, what it has to do with interest rates and why the Federal Reserve chairman is the most closely watched economist in the world.

Let's start with a basic introduction to interest rates.