Back to Basics: Interest Rates

When people borrow money from a lender, they're responsible for the total amount they borrowed plus a percentage of that amount called interest. Interest is often referred to as "the price you pay to borrow money."

On a larger scale, interest rate changes can act like an economic barometer, indicating how well the economy is performing. The federal government attempts to stabilize the economy by setting and adjusting the prime interest rate. If the economy is performing well, interest rates are typically higher. When there’s an economic slowdown, interest rates will be lower to stimulate spending and economic growth.

Interest rates are not one-size-fits-all. In related content, we’ve explored short- and long-term interest rates, the differences between an annual percentage rate (APR) and an interest rate and how to prepare your business for the possibility of rising interest rates. But you may still have questions about the basics.

Let’s take a step back and talk about why interest rates exist and what role(s) they play within our economy.

What role does interest play in our economy?

Interest rates allow a lender to earn money and hedge against the risk of loaning out money. While you may typically think of lenders as banks or loan providers, you are actually filling the lender role when you store your money in a checking, savings, CD, money market or other type of account. This is why you may earn interest when you deposit money into these types of accounts.

Interest rates should be an important consideration before you take out or refinance a loan, or use a credit card or Buy Now, Pay Later (BNPL) to purchase goods. In these instances, interest is a cost paid for the convenience of borrowing money instead of paying for an item or service outright with cash.

How are interest rates set?

Interest rates in the United States ebb and flow by the Federal Open Market Committee (FOMC). The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates, according to the US Federal Reserve’s official government website.

The Federal Reserve (or “Fed” for short) pulls economic levers like interest rates at these periodic intervals to help promote national economic goals and stability.

Why do interest rates change?

Interest rates are intrinsically related to the performance of the economy. The availability of credit, or money that can be loaned, operates on supply and demand. When the cost to borrow money is lower, typically the availability of money to borrow is higher, and vice versa.

The Fed will increase or decrease interest rates in response to economic changes. For example, the Fed might increase interest rates to help stem inflation or lower interest rates when the economy is struggling to further promote buying goods and services. 

Interest rate types

Now that we know the why of interest rates, it’s good to key into how these various interest rates rise and fall. To understand this, it’s helpful to know the seven types of interest rates:

• Fixed Interest Rate: As the label implies, this rate remains fixed (unchanged) throughout the term of the loan. Loans set up with this type of interest are the easiest to budget around because loan payments are predictable.
• Variable Interest Rate: These loans have interest rates that are subject to change. These rates usually fluctuate with prime rate fluctuations (more on that below). When deciding on a loan, consider the long-term cost of borrowing that money.
• Annual Percentage Rates: Or APR are most commonly associated with credit cards or investments – these rates are the cost to borrow money over an entire year. Remember that APR takes into account any fees associated with getting a loan. Borrowers will carry a balance with their lender and can pay all or some of the interest incurred at monthly intervals.
• Prime Interest Rate: These are reserved for banks' preferred customers — essentially, those who demonstrate the least amount of lending risk through factors like income, credit score and debt history. The prime rate tends to reflect whatever the Fed has set for a rate.
• Simple Interest Rate: These rates leave nothing to question. Usually, this is the formula for calculating such a straightforward agreement: the principal multiplied by the fixed interest rate multiplied by the number of payment periods.
• Compound Interest Rate: This is the interest charged on the sum of the principal loan and the total amount of interest amassed so far. Some call it "interest on interest."

Budgeting for a loan

When budgeting for a loan, be sure to consider both impending economic factors at large (inflation, world events that might impact spending, etc.) and also the type of interest rate your loan will carry. Try to look at the big picture – one type of loan might offer a lower up-front interest rate or payment but further into the life of the loan, you may experience increases in the interest rate.

Leveraging your knowledge of interest rates can also greatly facilitate refinancing a mortgage or loan consolidation. If you factor in your personal situation, the economy and your loan options,, you can make an educated decision that aligns with your financial goals and priorities!

There are some great resources online that can aid in your loan decisions. Online planning tools can facilitate the selection and configuration of larger loans, like a mortgage. The Consumer Financial Protection Bureau offers an interest rate exploration tool that demonstrates how your credit score, loan type, home price and down payment can impact your mortgage rate.

Have more questions about loans for purchasing a home? Our expert mortgage loan officers have years of experience helping those shopping for homes in Massachusetts and Rhode Island find the right mortgage solution that fits their short and long-term financial needs and goals.

Back to Basics Series

Don’t miss our entire “Back to Basics” series, which explores topics like inflation, mortgages, and how to avoid scams.

If you love podcasts, our financial education, development & strategy officer Julie Beckham hosts a podcast series called Mini Money Minutes, which explores similar topics in just five minutes. These bite-sized episodes can help you quickly learn more about your finances.