When money is borrowed, an interest rate is usually attached to the principal sum. Essentially, an interest rate is the price or cost for the “use” of money between a borrower and a lender. It is often expressed as a percentage of the principal. For example, if you were to borrow $1,000 from a lender, and they charge you $50 on an annual basis, the interest rate is then 5% (50/1,000*100%).
Interest can be calculated as simple interest or compound interest. With a simple interest rate of 5% on a $1,000 loan, the annual interest payment would be $50 for the life of the investment. With compound interest, the interest rate is “compounded” since the interest rate is taken year after year on the sum of the investment. To further explain with the same example, if $1,000 is invested at 5% interest, the first year of interest would be $50 (5% of $1,000). However, the second year the interest would be $52.50 (5% of $1,050). This pattern continues for the life of the investment.
Interest rates can change depending on the riskiness of the investment. In a high-risk investment, interest rates will need to be similarly high to compensate for the added risk taken on by the lender (risk of a default on the investment). The level of risk is important to take into account when comparing different interest rates.
In financial markets, fluctuations in the interest occur when there is a change in the supply and demand of credit. When there is excess supply of credit, interest rates tend to go down to entice borrowers to take out more loans. When borrowers are taking out more loans due to activities like investing and spending opportunities, interest rates tend to go up. People with good credit scores can often times negotiate for a lower interest rate, since they are “less risky investments” from the lending institution’s perspective.