What is an interest rate?

An interest rate prices time. It is what a borrower pays for using someone else’s money now instead of later, and what a saver earns for waiting instead of spending, expressed as a percentage of the amount involved per year. Everything else about interest rates — mortgages, savings accounts, credit cards, central banks — is a variation on that single exchange.

One economy, many rates

A mortgage rate, a savings rate, a credit card rate and the rate banks charge each other overnight are not the same number wearing different labels. They diverge because three things differ underneath: risk, duration and competition.

Risk is the chance the money doesn’t come back. A mortgage is secured against a house, so if a borrower stops paying, the lender can eventually recover something. A credit card balance is secured against nothing beyond a promise, so card rates run far higher to compensate for the losses the lender expects across all its cardholders. Duration matters because locking money away for thirty years carries different uncertainty than lending it overnight — long-term lenders want compensation for not knowing what the world will look like in year twenty-five. Competition matters because a rate is also a price, and prices fall where providers compete hard for your business and rise where they don’t.

Put a mortgage, a savings account and a credit card side by side and you’re really comparing three different risk-and-duration bets, each priced by a different competitive market.

The two sides of every rate

Every interest rate has two people standing on either side of it, and it means something different to each. The rate on your savings account is income to you and a cost to the bank holding your deposit. The rate on your mortgage is a cost to you and income to the bank that lent you the money. There is no such thing as an interest rate that is purely good or purely bad — it depends entirely on which side of the transaction you’re standing on.

Banks make their living in the gap between the two. They pay savers one rate to attract deposits, then lend that money out at a higher rate to borrowers, and the difference — after covering costs and losses — is the bank’s margin. Watching both sides at once explains why banks are often quick to raise mortgage rates but slow to raise savings rates when borrowing costs rise generally: the wider the gap, the better it is for the bank sitting in the middle.

Where rates come from

Rates don’t emerge from nowhere — they take their cue from a policy rate set by a central bank. In the euro area, the European Central Bank’s Governing Council meets roughly every six weeks and sets three key interest rates as part of its job of keeping prices stable: the main refinancing operations rate, which is what banks pay to borrow from the ECB for a week; the marginal lending facility rate, for overnight borrowing; and the deposit facility rate, which applies to overnight deposits banks hold at the ECB. Commercial banks anchor their own mortgage, savings and lending rates to these policy rates, adjusting for the risk and duration of each product. Other central banks — the US Federal Reserve, the Bank of England and others — run the same kind of mechanism for their own currencies. The next guide looks at how a central bank’s policy rate actually moves through the economy to reach your mortgage or savings account.

Nominal against real

A rate only means something once you place it next to inflation. The number on your statement is the nominal rate; what it’s actually worth to you, after prices rise, is the real rate.

A 3% savings rate sounds identical in every year it appears, but its real value swings with inflation. Under 2% inflation, that 3% nominal rate leaves you with about 0.98% in real terms — your money is genuinely growing its purchasing power, just slowly. Under 5% inflation, the same 3% nominal rate becomes roughly -1.9% real — your balance grows in euro terms, but it buys less than it did a year earlier. The nominal rate never changes in this comparison; only the inflation next to it does, and that’s what decides whether saving is rewarding you or quietly losing you ground.

This is also why the euro amounts feel small until they compound. A €300,000 mortgage over 30 years costs €1,432.25 a month at a 4% rate; move that rate to 4.25% and the payment rises to €1,475.82, an extra €43.57 a month for a quarter-point change. Push it to 5% and the payment rises by €178.21 a month and €64,158 over the life of the loan. On the saving side, €10,000 left for five years grows to €11,051 at 2% and €11,616 at 3% — one extra percentage point is worth €565 to the saver over those five years. Small differences in the rate, compounded over real time, are where interest rates stop being an abstraction and start being money.