Why is there an interest rate?

Why is there an interest rate?

A basic understanding of interest rates and its economic influences is essential. Here’s a breakdown on why interest rates exist. 

Interest rate provides compensation to the lender for bearing risks 

A bank will charge higher interest rates if it thinks there’s a lower chance the debt will get repaid. For that reason, banks will always assign a higher interest rate to revolving loans, like credit cards. These types of loans are more expensive to manage.  

Banks also charge higher rates to people they consider risky. This is why it’s important to know what your credit score is and how to improve it as the higher your score, the lower the interest rate you’ll have to pay. 

Interest rates encourage people to save  

Interest rates directly influence consumers’ ability to earn decent returns on deposit accounts. As a result, banks pay you an interest rate on deposits because they’re borrowing that money from you. 

Banks make a profit from interest rates

Usually banks use the deposits from savings or checking accounts to fund loans. Banks charge borrowers a little higher interest rate than they pay depositors so they can profit. A bank will charge higher interest rates if it thinks there’s a lower chance the debt will get repaid. This way they still profit from having lend the borrower. 

Interest protects against future rises in inflation 

If inflation is expected to be high, the buying power of borrowed funds declines rapidly. In the event of expected inflation, banks demand a higher interest rate in order to financially protect themselves against the negative repercussions of inflation. 

Interest rate plays a role in your decision to borrow money. 

In simple terms, interest rates refer to the cost of borrowing money. When a bank lends you money, they charge you a percentage of that loan, which is payable monthly. Interest rates affect most people and the financial decisions they make. As very few of us are able to make large purchases without the assistance of a bank that’s willing to lend us capital. 

For example: A person or family may take out a mortgage for a house. For which they cannot presently pay in full, but the loan allows them to become homeowners now instead of far into the future. Borrowers then pay interest because they must pay a price for gaining the ability to spend now.

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