Interest is a fee or compensation paid by the borrower to the lender. By way of accumulation, the interest rate can be categorized into simple interest and compound interest. Please check the Compound Interest Calculator to see the difference.
In economics, the interest, or nominal interest rate, includes the current inflation rate and the real interest rate. The average inflation rate in the United States in the past 30 years has hovered around 4.3%. (Please check the Inflation Calculator for more detailed information.) This means you must have an average interest/return rate of 4.3% to not lose the purchasing power of your money. The average annual return rate of the S&P 500 (Standard & Poor's) index in the United States is around 7.5%. TIPS, or Treasury Inflation-Protected Securities, is a bond issued by the U.S. Treasury that provides protection against inflation.
The interest rate of a loan or saving can be "fixed" or "floating". Floating rate loans or savings are normally based on some reference rate, such as the U.S. Federal Reserve (Fed) funds rate or the LIBOR (London Interbank Offered Rate). Normally, the loan rate is a little higher and the savings rate is a little lower than the reference rate. The difference goes to the profit of the bank. Both the Fed rate and LIBOR are short-term inter-bank interest rates, but the Fed rate is the main tool that the Federal Reserve uses to influence the supply of money in the U.S. economy. LIBOR is a commercial rate calculated from prevailing interest rates between highly credit-worthy institutions. The following is a diagram of the Fed rate from 1954 to 2009:
Earning interest on savings in a money market account or CD is still a very viable way to invest your money.
Even though interest rates are low, regular contributions to this kind of account mount up throughout your working life, and can lead to considerable riches over the years. This is through the power of compound interest, and this interest calculator can help you to perceive it.
A saver who deposited $1000 each month in a savings account for 20 years from 1970 to 1990 had, at the end of that time, invested $240,000. Thanks to the power of compound interest, that saver now had more than $1 million dollars in the bank, however. It must have been nice to have become a millionaire after just 20 years of employment. Imagine what that person can do today, because, having just allowed that money to continue earning interest, it is now $4 million.
Of course, inflation is an important factor to consider, and the million today is not worth that much in real spending power. Still, it is a lot of profit. To cope with inflation, make other investments like bonds which earn higher rates that compete with inflation. But divide up your portfolio in terms of risk. And don't neglect the power of compound interest.