What Is an Interest Rate and How Does It Affect Your Finances?

An interest rate affects the price you pay to borrow money and the money you earn through savings and investments. As such, an interest rate is a key factor both when determining where to save or invest your money and whether borrowing money is the right financial move for you.

What is an interest rate?

An interest rate represents how much it costs to borrow money at any given time. If you borrow money for a car, house, or student loan, for example, you can think of the interest rate as how much it will cost you to take out that loan. When you deposit money into a savings account or invest in bonds, the interest rate represents how much you’ll earn on your money.

How do interest rates work?

An interest rate is shown as a percentage. The higher the interest rate percentage, the more you’ll pay as a borrower or earn as a saver or investor. Conversely, the lower the interest rate percentage, the less you’ll pay as a borrower or earn as a saver or investor. Events outside your control — such as inflation and the unemployment rate — influence interest rates. You have some control over what your interest rate will be when you borrow money. Your credit score, for example, plays a major role in whether you’ll be offered a higher or lower rate. Typically, the higher your credit score, the lower the interest rate you’ll qualify for, and the lower your credit score, the higher your interest rate will likely be.

Interest rates on loans and credit

When you want to borrow money for a car, student loan, or house, or when you use a credit card, you must pay back the borrowed money over time, along with interest to the lender.

Interest rates on savings and investments

When you save or invest money, you’re paid interest, typically called the return on your investment. The higher the interest rate the more you earn. There are many financial institutions that offer various types of savings accounts where you can save money, including:

• Credit unions
• Banks
• Online financial institutions

To find the highest interest rate, you can research which financial institution offers the best rate and which product suits you best. Some savings account types, for example, give you instant access to your funds but might offer a lower interest rate, while other types of accounts that offer a higher rate might require you to wait for a predetermined period before you can withdraw money.

Types of interest rates

Interest rates can be either fixed or variable. Here’s how each type works:

• Fixed interest rates: A fixed interest rate doesn’t change. Mortgages and car loans usually have a fixed rate. With a fixed-rate loan, your monthly payments shouldn’t increase. But you won’t get to benefit if interest rates drop.
• Variable interest rates: A variable interest rate is one that changes periodically. The interest rate could go up or down. Savings and investment accounts usually have a variable rate. Some mortgage loans have a variable rate. These are called adjustable-rate mortgages (ARMs), and they often have a lower interest rate than a fixed-rate mortgage initially. When the introductory period ends, your rate is likely to go up.

Annual percentage rate (APR) vs. annual percentage yield (APY)

Both APR and APY measure interest. Here are the differences:

Compound interest

Compound interest is interest paid on interest. Here’s an example of the power of compound interest from the Consumer Financial Protection Bureau: Suppose you save $1,000 at 5% interest that compounds yearly. After one year, you will have earned $50, which is 1,000 multiplied by 0.05. The next year, you will earn $52.50, which is $1,050 multiplied by 0.05.

In this case, you’ve earned interest on $1,050, not on $1,000. You earned interest on that $50, which was $2.50. That might not be too much, but this interest acts like a snowball, growing each year.

Factors that influence interest rates

Many factors can influence interest rates. Some, like economic indicators, are out of your control. You have some control over your interest rate when you borrow money, though, depending on your credit score and borrower profile.

Economic indicators

Whether interest rates are high or low at any given time depends on certain indicators. Two indicators are inflation and unemployment figures.

Inflation: The inflation rate tracks how the prices of goods change over time. How much inflation we’re experiencing is measured by the Consumer Price Index (CPI). As of February 2025, the U.S. inflation rate was 2.8%. 

The Federal Reserve aims for a target inflation rate of 2%; a lower rate means the economy isn’t growing and a higher rate means prices are rising and consumers’ purchasing power is limited. The Fed manages inflation using what’s called the federal funds rate, the rate at which banks lend to each other. Interest rates typically follow the federal funds rate. During inflationary times, the Fed tends to raise the federal funds rate to encourage consumers to save instead of borrow. When the economy is stagnant, the Fed might lower the federal funds rate to encourage borrowing over saving.

“Homebuyers might want to consider waiting for inflation to drop to 2%, and then the interest rates should drop as well,” says Austin Eltz, an Atlanta REALTOR®. 

Unemployment: When there’s low unemployment, inflation tends to rise, as do interest rates. When there’s high unemployment, the economy tends to stagnate. To encourage borrowing and stimulate the economy, the Fed might lower the federal funds rate.

Credit scores and credit history

Your credit report is a detailed summary of your credit history and how you’ve handled debt. The report is used to produce a credit score, which is an indicator of how likely it is that you'll pay back a loan. If your credit score is high, you’re more likely to get approved for a loan and qualify for a lower interest rate. If your credit score is low, you might not be approved for a loan, and if you are, your approval might come with a higher interest rate. Your credit score is determined by the following:

• Your payment history
• How much unpaid debt you have
• How many loans you have 
• How long you’ve had credit accounts
• How much of your available credit you’re using

Note: You might have several different credit scores because there are different credit scoring models, such as FICO and Vantage, and vaious methods of scoring within the models. When you look up your credit score, the number you get might differ from the number a lender sees.

Loan terms and amounts

A loan term is the length of time you have to pay back the loan. The longer the term, the lower your monthly payment will be, but the more you’ll pay in interest.

Your loan amount is how much you’re borrowing, also called the principal. The loan amount could affect your interest rate. This depends on the type of loan, the lender, and your credit history.

How interest rates impact your finances

Interest rates affect your finances whenever you borrow, save, or invest.

Cost of borrowing

When you borrow money, you should try to find the lowest interest rate possible. Let’s say you take out a mortgage loan of $450,000 at 3% interest. Your monthly payments would be around $1,897. That same loan with a 6.5% interest rate would mean your monthly payments would be around $2,844, a difference of $947 a month. Because interest rates have been on the higher side for much of 2025, Eltz says, “All of my buyers are waiting for interest rates to drop before they buy.”

Returns on savings and investments

When you save money, you want the highest interest rate possible. Let’s say you make an initial bank deposit of $10,000 and each month you deposit $200 to the account at 2.4% interest. After 10 years, you will have earned $5,803.89 in interest. That same deposit and contribution schedule at 5% interest will earn you $13,161.58 after 10 years, a difference of $7,357.69.

Personal budgeting and financial planning

Interest rates play a role in both personal budgeting and financial planning. Here’s how:

• Personal budgeting: When you’re thinking of borrowing money for a large purchase, such as a car or home, it helps to first make a household budget so you can see how much income and debt you have. Using this information, you can determine whether you can afford to take out a loan. Knowing the current interest rate helps you determine what your monthly payments will be.
• Financial planning: When you create a budget, it’s a good idea to set aside a certain percentage of your income for savings and investments. When you do, you’ll want to earn as much as possible on this money. You can research the possibilities, or you can hire a financial planner to help you. Probably the easiest way to start is with a bank savings account that pays a high interest rate.