Interest rates are a fundamental element of the financial system. They enable lending and investing, balance debtor and creditor needs, effectively distribute money, and promote economic growth. However, interest charges are not without drawbacks. Excessive interest rates increase the cost of borrowing, making it more difficult for individuals and businesses to pay back loans and putting them in financial danger. High interest rates also limit investment options, reduce savings, and make it harder for those on fixed incomes to reach their financial goals.
The type of loan or debt
Mortgage loans, for example, typically carry lower rates than personal loans and credit card debt. This is because mortgages are backed by real property, which the lender can liquidate to cover any losses if the borrower fails to pay. Personal loans and credit cards are not secured by assets, so they have higher interest rates.
Bank policies
Financial institutions determine their interest rate based on several factors, including their own financial needs and strategic objectives. For example, banks may raise their interest rates during periods of low consumer spending to attract deposits and encourage more borrowing. They may also lower their interest rates during times of high consumer spending to discourage borrowing and stimulate saving.
In addition, the rate of return on an investment or savings is determined by how much interest the initial principal earns over time. This is known as compounding. Some investments, such as bonds and short-term GICs, work this way. Others, such as savings accounts and some mutual funds, earn a simple interest rate that is not subject to fluctuations.