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Definition
An interest rate is the price of borrowing money, or the reward for saving it, expressed as a percentage of the amount borrowed or saved per year.
How it works
Simple interest for one year is principal × rate. Rates differ by borrower, loan length and risk: a lender asks for more when repayment is less certain or the money is tied up longer. A central bank sets a short-term policy rate, which influences the rates banks pay on deposits and charge on loans. Longer-term rates also reflect what markets expect for inflation and future policy.
The quoted rate is a nominal rate. The real rate adjusts for inflation: real rate = (1 + nominal rate) ÷ (1 + inflation) − 1, which is close to nominal rate − inflation when both are small. A positive real rate means savings gain purchasing power; a negative one means they lose it even while the balance grows.
Interest rates also affect asset prices. A bond pays fixed amounts, so when market yields rise, existing bond prices fall, and when yields fall, prices rise. More broadly, higher rates tend to lower the present value, or value today, of cash expected in the future, which can weigh on stock and property valuations. This is a tendency, not a fixed rule, because expectations for growth and risk also change.
Example (hypothetical numbers)
Suppose you put $5,000 in a 1-year deposit paying 4% a year, while inflation over that year is 3%.
Interest = $5,000 × 4% = $200, and the real return = 1.04 ÷ 1.03 − 1 ≈ 0.97%, so purchasing power grows by just under 1%.
Bond X pays $1,000 in 1 year. At a 5% market rate, its price today is $1,000 ÷ 1.05 ≈ $952.38.
If the market rate rises to 6%, the price becomes $1,000 ÷ 1.06 ≈ $943.40.
The nominal rate overstates the gain in purchasing power, and a higher rate lowers today's value of a fixed future payment.
Common mistakes
- Judging the return on savings by the nominal rate while ignoring inflation.
- Assuming a central bank rate change moves every loan and deposit rate by the same amount at once.
- Forgetting that existing bond prices fall when market interest rates rise.
- Comparing rates with different compounding or fee terms as if they were equal.
Related calculators
This glossary is for education only and is not investment advice. Examples use hypothetical numbers.