Borrow $1,000 for one year at 5%, and the interest costs $50. At 6%, it costs $60. For this example, you repay everything at year-end, with no fees, taxes or compounding.
Beside it, put two made-up annual offers: 4% on savings and 7% on a loan. Both quote interest rates. Neither has to match the rate in a Fed headline.
What is each rate pricing?
The price of using money
Interest is the payment for using someone else's money. An interest rate expresses that payment as a percentage over a stated period. The percentage applies to the principal: the borrowed amount still owed, excluding interest.
At 5%, $1,000 × 0.05 = $50. At 6%, $1,000 × 0.06 = $60. The bars show a $10 gap for using the same money over the same year.
At 5%, the full repayment is $1,050: your $1,000 principal plus $50 for using it.
Moving from 5% to 6% is one percentage point, or 100 basis points. Calling it a "1% increase" would mean something different.
A rate needs a clock: 5% a year and 5% a month are different prices. When interest itself starts earning interest, compounding changes the bill or balance.
There is no single interest rate
Saving reverses your role: the bank pays to use your money. The 4% savings rate and 7% loan rate price different transactions. A rate in the news may describe a different transaction again.
- Policy target. The Federal Reserve, the US central bank, chooses a target range for the federal funds rate, an overnight borrowing rate for banks. Even this overnight rate is quoted per year.
- Market yield. Investors buying and selling bonds set their prices. The resulting yield relates a bond's promised payments to its market price.
- Customer offer. Lenders choose the rates they offer borrowers; banks choose what they pay on savings.
Lending for a day is a different commitment from lending for years. Rates also reflect the chance of not being repaid and the inflation a lender expects while waiting. A lender wants compensation for both repayment risk and lost purchasing power.
Competition matters, too. A bank trying to attract deposits has a reason to offer savers more. The Fed influences those choices; it does not set your mortgage or savings rate.
Inflation changes the real cost
Your loan agreement counts dollars. Inflation changes what those dollars buy.
The nominal interest rate is the quote before adjusting for inflation. The expected real interest rate measures the borrowing cost in purchasing power, using the inflation you expect.
Subtracting expected inflation gives a quick approximation. Both rates must cover the same period.
For your 5% loan, suppose you expect 3% inflation over the year. The expected real cost is about 2%: 5% − 3%.
Suppose inflation instead ends up at 6%. The realized real interest rate uses that actual outcome, giving about −1%: 5% − 6%.
| Nominal rate | Inflation | Approx. real rate |
|---|---|---|
| 5% | 3% expected | 2% expected |
| 5% | 6% realized | −1% realized |
The $1,050 repayment now buys less than the $1,000 bought when you borrowed it. Your lender gets more dollars back but less purchasing power.
The bill is still $1,050. Inflation changed its purchasing power; it did not erase a dollar you owe.
How one change travels
When the Fed raises its target, a bank faces a higher cost for some short-term borrowing. That can feed into higher rates on new loans. It may also raise savings offers to attract deposits. These changes need not arrive together or match the policy move.
The contract decides when a borrower feels the change:
- Fixed-rate borrowing keeps the agreed interest rate unchanged for the loan's term.
- Floating-rate borrowing ties the rate to a specified market rate. The contract sets when it resets and any limits on the change.
- Refinancing replaces an old loan with a new one at new terms.
Longer-term rates also reflect expected future policy and economic conditions. Markets can move before the Fed does.
Investors also compare their alternatives. When low-risk bonds offer more, investors have a reason to demand more from riskier investments. That is one reason stocks care about interest rates.
Before reacting to "rates rose," check three labels: which rate moved, the period it covers, and whether it is nominal or inflation-adjusted.
For your one-year loan locked at 5%, a rise in the overnight policy rate leaves the $50 interest charge alone. The headline changed; your contract did not.
In short
- An interest rate prices the use of money over a stated period.
- Saving and borrowing put you on opposite sides of that price; their rates need not match.
- A rise from 5% to 6% is one percentage point, or 100 basis points.
- Expected inflation gives an estimate of the real cost; actual inflation determines the realized real rate.
- A policy-rate change can affect new offers without changing an existing fixed-rate loan.