Interest Rates

AuthorJeffrey Wilson

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In the world of banking and finance, interest is money that is paid by a borrower to a lender in exchange for the use of the credit. Money held in an account, such as a bank savings or checking account, may earn interest also because the bank has use of the money while it is held in the account and the interest constitutes payment to the account holder for the temporary use of the money.

Typically, interest is computed as a percentage of the amount borrowed, which is known as the principal. Interest may be computed on a yearly basis, which is known as simple interest. For example, if a borrower borrows $1,000 at a simple interest rate of 12 percent, with the loan due to be repaid in one year, the total interest owed on the loan is $120. Alternatively, interest may be compounded. With compounded interest, the calculation of interest occurs periodically and unpaid interest is added to the premium. For example, assuming a loan of $1,000 with a 12 percent interest rate compounded monthly, the interest that accrues during the first month of the loan is $120. That amount is added to the principal, making the total amount $1,120. The interest accruing during the second month of the loan—12 percent of $1,120—is $134.40. With compounded interest, the interest rate stays the same but the amount of interest may increase periodically.


Interest on borrowed funds has existed since ancient times, but interest was not always an acceptable means of conducting business. Religious groups in the Middle Ages—Jewish, Christian, and Islamic—forbade the use of interest, considering it reprehensible. Romans in ancient times also outlawed the practice of charging interest, as did the English government until the thirteenth century. In time, and with increasing demands for credit to support the growth of commerce and trade, a distinction was made between moderate interest rates and excessive interest rates. Chinese and Hindu laws prohibited excessive interest rates, known as usury, and in 1545, England set a maximum rate of interest. Other countries followed England's practice. In the United States as of 2002, the payment of interest for loans is a widely accepted business practice, with illegal usury reserved for interest rates exceeding the maximums set by law.

Interest and Inflation

Interest rates fluctuate constantly. They are controlled by supply and demand and other economic indicators. Other factors that help determine an interest rate include the length of the loan and any collateral used to secure the loan in the event the borrower cannot repay the loan. Low interest rates can

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stimulate the economy; consumers are attracted to low interest rates on consumer goods, cars, and houses and may spend more when interest rates are low. High interest rates usually have the opposite effect. Consumers are reluctant or unable to spend money, or spend as much money, when interest rates climb.

The Federal Reserve Board of Governors, part of the Federal Reserve System, sets a benchmark interest rate known as the prime rate. The Federal Reserve, the central bank of the United States, was founded in 1913 to help regulate the country's money supply. The goals of the Federal...

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