How Interest Rates Work

An interest rate is the cost of borrowing money [source: Investopedia]. A borrower pays interest for the ability to spend money now, rather than wait until they've saved up the same amount. Interest rates are expressed as an annual percentage of the total amount borrowed, also known as the principle. For example, if you borrow $100 at an annual interest rate of 5 percent, at the end of the year you'll owe $105.

Interest rates aren't just random punishments for borrowing money. The interest a lender receives is their compensation for taking a risk [source: Investopedia]. With every loan, there's a risk that the borrower won't be able to pay it back. The higher the risk that the borrower will default (fail to repay the loan) is, the higher the interest rate. That's why maintaining a good credit score will help lower the interest rates offered to you by lenders.

The nice thing is that interest rates work both ways. Banks, governments and other large financial institutions need cash, too, and they're willing to pay for it. If you put money into a savings account at a bank, the bank will pay you interest for the temporary use of that money. Governments sell bonds and other securities for the same reason. In this case, you're the lender, and the interest rate is your compensation for temporarily giving up the ability to spend your cash. Unfortunately, savings accounts and government-issued bonds pay relatively low interest rates because the risk of defaulting is close to zero [source: Investopedia].

A borrower's credit score is only one of the risk factors that affect interest rates. For example, interest rates for unsecured credit will always be higher than secured credit [source: Investopedia]. Secured credit is backed by collateral. A mortgage is the classic example of secured credit, because if the borrower defaults on the loan, the bank can always take the house. Credit cards are unsecured credit, because there's no collateral backing the loan, only the cardholder's credit score. Mortgage interest rates are typically much lower than credit card interest rates because they're less risky for the lender.

Long-term loans also carry higher interest rates than short-term loans, because the more time a borrower has to pay back a loan, the more time there is for things to go rotten financially, causing the borrower to default [source: Investopedia].

Another factor that makes long-term loans less attractive to lenders – and therefore raises long-term interest rates – is inflation. In a healthy economy, inflation almost always rises, meaning the same dollar amount today is worth less five years from now. Lenders know that the longer it takes the borrower to pay back a loan, the less that money is going to be worth.

That's why interest rates are actually calculated as two different values: the nominal rate and the real rate. The nominal rate is the interest rate set by the lending institution. The real rate is the nominal rate minus the rate of inflation. For example, if you take out a mortgage with a nominal interest rate of 10 percent but the annual rate of inflation is 4 percent, then the bank is only really collecting 6 percent on the loan [source: FRBSF].

But perhaps the most important, and certainly most talked about interest rates are those set by the Federal Reserve, which we'll examine next.