Last chance: €4,000 Early Bird discount on all MBA applications with deadline April 30, 2026

Interest Rates

Interest is a fundamental component of the financial system and represents the cost of borrowing money or the income from lending money. It is a major incentive for savers and investors and influences the behavior of borrowers and lenders. Interest rates affect almost all economic activities, from consumer finance and corporate investment to national and international economic policy.

Everything you need to know about interest rates in brief

What is interest simply explained?

Interest is the price that someone pays to borrow money or that someone receives when they lend money. When you borrow money from a bank, you have to pay interest - this is a fee for using the money. When you put money into a savings account, you earn interest because the bank can use your money. Interest can be seen as a reward for saving or as a cost for borrowing money.

Interested in Studying Business Administration?

Request information material now!

Types of interest

Interest rates can be divided into different categories, each reflecting different aspects of interest rates and their impact on economic transactions. The most important types of interest are nominal interest, real interest and effective interest. These categories help to understand the different dimensions of interest income and costs, whether in terms of accounting for inflation or the actual cost of borrowing. Differentiating between these types of interest rates is crucial to making informed financial decisions and correctly assessing economic conditions.

Nominal interest rate: The nominal interest rate is the interest rate that is contractually agreed and expressed in nominal (not inflation-adjusted) amounts. It is the simple interest rate that you see on your loan or savings account. The nominal interest rate does not take into account inflation, which affects the purchasing power of money.
Real interest rate: The real interest rate takes inflation into account and reflects the actual purchasing power of interest. It shows how much you actually gain or lose when inflation is taken into account. It is calculated using the formula Real interest rate = nominal interest rate - inflation rate. A positive real interest rate means that the money is gaining purchasing power, while a negative real interest rate indicates a loss of purchasing power.
Effective interest rate: The effective interest rate includes all additional costs and fees of a loan and provides a realistic representation of the actual loan costs. It provides a comprehensive overview of the total costs associated with a loan and is therefore an important indicator when deciding for or against a loan. In addition to the nominal interest rate, the effective interest rate also takes into account administrative costs, processing fees and similar expenses.

Interest calculation

Simple interest calculation: The simple interest calculation is based on the original capital amount without taking compound interest into account.
The formula is: interest = principal × interest rate × time. This method is often used for short-term loans or deposits where interest is not calculated on the original interest earned.

Compound interest: With compound interest, the interest is calculated on the original capital as well as on the interest already accrued. This leads to exponential growth of the invested capital. The formula is: interest = capital × (1 + interest rate)^time - capital. This method is often used for long-term savings and investment accounts as it maximizes returns.

Examples to illustrate this:

Example 1: A savings account with an interest rate of 5% per annum on €1,000 over 3 years.
With simple interest calculation, the profit is: €1,000 × 0.05 × 3 = €150.
With compound interest calculation, the profit is: €1,000 × (1 + 0.05)3 - €1,000 ≈ €157.63.
Example 2: A loan with an interest rate of 7% p.a. on €5,000 over 2 years.
With simple interest calculation, the interest is: €5,000 × 0.07 × 2 = €700.
With compound interest calculation, the interest is: €5,000 × (1 + 0.07)2 - €5,000 ≈ €745.50.

Interested in Studying Business Administration?

Request information material now!

Factors that influence interest rates

Inflation

Higher inflation rates often lead to higher interest rates, as lenders demand compensation for the devalued purchasing power of the money repaid. Central banks often raise interest rates to combat inflation, which in turn increases borrowing costs for consumers and businesses.

Central bank policy

The monetary policy of central banks, such as the European Central Bank (ECB) or the Federal Reserve, plays a decisive role in setting interest rates. By controlling key interest rates, central banks influence general interest rates in the economy, which in turn influences borrowing and lending as well as general economic growth.

Supply and demand in the credit market

A high supply of available credit with low demand tends to lead to lower interest rates, while high demand with low supply drives up interest rates. These market conditions are influenced by numerous factors such as economic sentiment, availability of capital and lending criteria.

Economic conditions

General economic conditions, such as business cycles, unemployment rates and economic growth, have a direct impact on interest rates. In an expanding economy, interest rates tend to rise to prevent overheating, while in times of recession they are lowered to stimulate economic activity.

Role of central banks

Control of interest rate policy: Central banks control interest rate policy by setting key interest rates, which serve as a reference for other interest rates in the economy. These measures directly influence the cost of credit and the availability of money in the economy.

Influence on the economy: By adjusting interest rates, central banks can control economic growth, inflation and the unemployment rate. Low interest rates encourage investment and consumption, while high interest rates encourage saving and dampen inflation.

Monetary policy instruments: Central banks use various instruments such as open market operations, reserve requirements and lending to banks to control the money supply and interest rates. These instruments help to ensure price stability and balance out economic fluctuations.

Interested in Studying Business Administration?

Request information material now!

Interest in the lending business

Significance for borrowers and lenders: For borrowers, interest rates determine the cost of borrowed money, while for lenders they represent the return on money lent. Interest rates therefore influence the attractiveness of loans and the willingness to lend.

Different interest rates for different types of loan:

Mortgage rates: Long-term loans to finance real estate, often with lower interest rates due to the collateral.
Consumer loans: Short-term loans for personal use, usually with higher interest rates due to the higher risk.
Corporate financing: Loans to finance business activities, which can vary depending on the size of the company and creditworthiness.

Effects on borrowing and lending: High interest rates can dampen borrowing and slow down investment, while low interest rates can encourage borrowing and boost economic growth. Interest rate policy therefore has a direct impact on economic activity and the investment decisions of companies and private individuals.

Interest as an investment instrument

Savings interest: Banks pay interest on deposits in order to attract deposits and secure liquidity. This interest varies depending on market interest rates and the economic situation.

Bonds and bonds: Bonds offer fixed or variable interest payments over the term of the bond. They are a safe investment option and provide regular income for investors.

Interest as a source of income for investors: Interest from savings, bonds and other fixed-interest securities provides a regular source of income and is an important part of the portfolio of risk-averse investors.

Historical development of interest rates

Trends and changes over time: Interest rates have changed significantly throughout history, influenced by economic conditions, political decisions and global events. Periods of low interest rates have often followed economic crises to stimulate growth, while periods of high interest rates have been used to combat inflation.

Influence of historical events on interest rates:

Great Depression: Led to extremely low interest rates to revive the economy.
1970s oil crises: Caused high inflation and interest rates.
2007-2008 Financial Crisis: Resulted in a sharp drop in interest rates to support economic recovery.

Interested in Studying Business Administration?

Request information material now!

Our university. Awarded and accredited.

Did you find this article helpful? Do you have any suggestions or questions about this article? Have you noticed something or is there a topic you would like to know more about? Your feedback is important to us! It enables us to constantly improve our offer and provide you with exactly the content you are interested in.
Contact editorial office

Note on readability and salary information: The salary ranges given refer to Germany.