The inflation rate and interest rates have a profound impact on how the economy works. Understanding how they interact can help you manage and invest your money better.
The inflation rate is the rate at which prices are increasing in the economy. This is often measured by observing changes in the price of a set bundle of common consumer goods, known as the consumer price index (CPI).
Interest rates are the rates that people or organizations pay to use the money of other people or groups -- essentially the price of borrowing money.
Risk plays a large role in determining interest rates. Lenders will give you a lower rate if they believe you are more likely to pay them back. Credit scores are a means for lenders to determine the risk of lending to a certain borrower.
Real Interest Rates
Real interest rates are calculated by subtracting the inflation rate from a nominal interest rate, such as the rate paid on a savings account. Real interest rates are the net gain of interest charged on borrowed money, taking the inflation rate into account.
It is possible for the inflation rate to be negative, which is called deflation, meaning that prices are falling throughout the economy.
APR Vs. Effective Interest Rate
Interest rates can be confusing. Sometimes they are expressed as an annual rate (i.e. APR), sometimes they are expressed for the compounding...