What is Interest Rate in Simple Terms?

Interest is the amount or price that a person pays for the transitory use of funds of another person.

The interest can also mean the payment which a person receives when they give up their willingness to spend money temporarily and lend their money to be used by a loan lending agency such as banks.

This definition also clearly describes the relation between a borrower and a lender. Moreover interest rates are also found constantly in the news and almost everyone is aware that it has a crucial effect on the economy and on personal finance.

However the confusing array of interest rate could also any individual confused if they are not finance field friendly. Therefore you can just follow a simple guide that could enlighten you about interest rates and the effect they have on individuals and the economy.

Interest rates explained

Interest rate is normally referred to the cost of money received when you lend your money to be used by another person or organization.

They are referred as cost of money because the rates determine the overall cost involved in borrowing the money. So, when the market rate of interest is high there would be discouragement to the borrower, but in this case saving money could be very beneficial.

There is also something called as real interest rates, which is equal to the nominal rates excluding the inflation. You should remember that impact of interest rates mainly depends on the inflation interest rates.

This means that when the interest rate is around 10 percent then the inflation rate would be 9 percent. Therefore this means, saving money in the bank would give you just one percent of real interest rate.

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However when the interest rate is around 5 percent with 3 percent of inflation rate, it means that the real interest rates are really high than the previous one.

During the deflation period the real interest rates could be quite high although the nominal rates are a bit lower.

Base interest rates

The base interest rate is considered as the main rates by monetary authorities. In the United Kingdom the base rates are given out by Bank of England while in the United States, the Federal Reserve sets the base rates.

However the base rate is also the ultimate rate at which most of the commercial banks borrow funds from Central Bank which therefore influences all the other interest rates in the economy.

You should note that the Federal Reserve does not control any commercial interest rates but it does control base rates.

Interest rates and country’s economy

You should know that the economical growth is largely influenced by the inflations and interest rates.

Basically when there is higher rate of interest it would reduce consumer spending and shrink investments. This in turn would slow down the economic growth of the country and also reduce the inflation.

Therefore the Monetary authority faces trade off between slower economic growth and reducing inflation.