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An interest rate is the cost of borrowing money, or the compensation for assuming the risks of lending money. Interest is a cost for one party, and income for another. Regardless of the perspective, interest rates are always changing.

An increase in demand for credit will raise interest rates, while a decrease will lower them. The more that banks can lend, the more credit that’s available to an economy. And as the supply of credit increases, the price of borrowing – or interest – decreases.

Credit decreases and interest rises when lenders don’t repay their loans. If you skip paying this month’s credit card bill, you increase the amount of interest you owe, and decrease the amount of credit available.

Another force is inflation. Higher inflation is likely to raise interest rates because lenders will want to make up for lost purchasing power.

The federal funds rate is the rate institutions charge each other for short-term loans. It affects the interest rates banks charge, and that trickles down into other short-term lending rates. The Fed influences these rates by buying or selling U.S. securities. When it buys them, it injects banks with more money to lend, which decreases interest rates. When it sells, banks have less money to lend and interest rates rise.

Interest rates also depend on the riskiness of the borrower. Greater risks lead to higher interest rates. Long-term loans have a greater chance of repayment default, and therefore higher rates. And if a loan can be quickly converted into cash, it usually has lower interest rates.

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