Interest rates play a critical role in your financial life. They influence the price of borrowing, the profitability of savings vehicles and more. Yet, they can sometimes be a bit complicated to understand and can make it difficult to assess which options are best for your needs. Whether you’re taking out a mortgage, a credit card or saving for retirement, understanding the factors that go into interest rates can help you make better financial decisions.
An interest rate is essentially a reward that lenders receive for taking on risk and lending you money. Lenders don’t work on the honor system – they expect to get paid back for their investment. The exact amount of the return is determined by your lender or bank and varies based on things like the type of loan and the economic environment.
Generally speaking, interest rates rise when demand for loans is high and fall when demand is low. They can also change based on factors such as inflation and monetary policy. The Federal Reserve, the US central bank, sets an overnight target rate for banks called the federal funds rate that influences all other rates.
Ultimately, the decision of whether to choose a fixed or variable rate depends on a variety of factors including your comfort level with financial risk and market trends. If you’re comfortable taking on some risk and believe that interest rates will eventually go down, then a variable rate may be the right choice for you. But remember, that when you choose a variable interest rate, your monthly payments will start out higher than with a fixed rate loan.