Interest rate
BankingDefinition
An interest rate is the cost of borrowing money, or the reward for lending it, expressed as a percentage per year. It is fundamentally the price of time - compensating the lender for giving up access to their money and for the risk that the borrower might not repay.
Interest rates are set by two forces: the Federal Reserve (which sets the overnight Fed Funds rate) and the market (which determines rates for everything else based on supply, demand, and risk). When the Fed raises rates, borrowing gets more expensive across the economy - mortgages, car loans, credit cards, and corporate debt all adjust upward.
Higher rates slow the economy (less borrowing = less spending = less inflation). Lower rates stimulate it (cheap borrowing = more spending = more growth). This push-pull is the Fed's primary tool for managing the economy.
For investors, the risk-free rate (3-month T-bill) is the baseline. Every other investment must offer a premium above this rate to compensate for risk.
Interest rates are set by two forces: the Federal Reserve (which sets the overnight Fed Funds rate) and the market (which determines rates for everything else based on supply, demand, and risk). When the Fed raises rates, borrowing gets more expensive across the economy - mortgages, car loans, credit cards, and corporate debt all adjust upward.
Higher rates slow the economy (less borrowing = less spending = less inflation). Lower rates stimulate it (cheap borrowing = more spending = more growth). This push-pull is the Fed's primary tool for managing the economy.
For investors, the risk-free rate (3-month T-bill) is the baseline. Every other investment must offer a premium above this rate to compensate for risk.
Example
At 6.5% mortgage rate on a $320,000 loan:
• Monthly payment: $2,023
• Total interest over 30 years: $408,000 (more than the loan itself!)
• At 3.5% instead: $1,437/month, total interest $197,000
That 3 percentage point difference costs you $211,000 over the life of the loan.
• Monthly payment: $2,023
• Total interest over 30 years: $408,000 (more than the loan itself!)
• At 3.5% instead: $1,437/month, total interest $197,000
That 3 percentage point difference costs you $211,000 over the life of the loan.