Everybody is a borrower and a lender in today’s economy. Every time a person uses a credit card, they are borrowing money from a credit lender. In each transaction, interest is involved. But what is interest exactly, and how does it work?

What is Interest?

Interest is either what you pay when you borrow somebody else’s money, or what you receive when you lend your own money to somebody else. It is an extra charge that is added to most borrowed money, and is usually calculated over time, so the longer it takes to repay a loan, the more interest will be added.

There are three main factors to calculate interest: the interest rate, the principal amount (original amount borrowed), and how long it will take to repay the loan. If you have agreed to a higher rate of interest or a longer-term loan, you will end up paying more.

For lenders, several factors go into deciding how much interest is charged and what kind. Some important aspects would include projected inflation, credit risk, and liquidity (how much cash the borrower has).

What Are Interest Rates?

The interest rate is set according to the supply of money from lenders, and the demand for that money by borrowers.

Interest rates play an important role in the economy as they affect the money supply and credit markets. Therefore, they can have a positive effect or a negative one. High rates make borrowing more expensive and can deter consumers or businesses from applying for loans. Low rates make borrowing cheaper, but they can encourage excessive borrowing.

In the U.S., the Federal Reserve establishes the interest rates as the amount banks charge each other for overnight loans. Generally, the federal government and the central bank prefer low interest rates. The fed funds rate has been below the 2% mark for most of the 21st century, a measure taken to boost economic growth.