Interest rates. Two words that all of us are all too familiar with, although few of us fully understand the reasons behind the numbers. Yet interest rates affect almost every aspect of our financial life — the cost of using credit and store cards, the amount of money earned on a bank account, the cost of buying a car or house. The entire economy of the country is affected in some way by the current interest rate.

Simply put, the interest is the amount of money that it will cost you — or a bank - to borrow a certain amount of money from another bank or money lender. The interest rate is how this amount is measured — if you borrow $100 at a rate of 10%, you will be paying back $110. The concept can become even more complicated when dealing with large sums of money paid back over a long period of time, such as a mortgage. If you take a close look at your mortgage statement, you may be surprised to see just how much of your monthly payment is going towards the interest. Interest rates are notoriously difficult to forecast and there are several reasons as to why they can change.

But who decides what the interest rate should be? The job of monitoring the economy and adjusting the key interest rate if necessary belongs to the Federal Reserve Bank. Within the bank is a department of about a dozen economists which meets at least 8 times a year to decide if, when and by how much to raise interest rates. The basic reason why the interest rate might be raised — or lowered - is generally to boost the overall economy, and allow for long term growth and prosperity.

By raising the interest rate even slightly, banks and other financial institutions are then charged more to borrow money from each other. This increase in cost is passed onto the consumer — it will cost slightly more to take out a mortgage or a home equity loan. Even credit card loans and other smaller loans will pass on the increased cost to the consumer. The end result is that more money is being spent and earned.

Basic supply and demand for available money is also one of the biggest factors affecting interest rates. To use the mortgage market as an example, if more and more people are buying and financing houses, more money is being borrowed, which means that lenders can charge higher rates to borrow the money. Similarly, in a slow economy, less people are borrowing money, the rates tend to be lower to attract customers, and there is more money to lend. Most people are conscious of interest rates when taking out a mortgage - an increase in the interest rate on your mortgage of just a percentage of a point can mean an extra payment of several hundred dollars over a year and thousands of dollars over the term of your mortgage.

Inflation, which is defined as the general average change in the level of prices, also has an effect on interest rates. If inflation is high — or set to rise — investors will need a higher interest rate to consider lending money for more than the shortest term. The level of employment can also have an effect on interest rates — little unemployment generally means a strong economy. At the moment of course, we have high unemployment along with a poor economy.

The government’s monetary policy can also have a significant effect on interest rates. Simply put, it is possible for the central bank to ”˜create’ more money by just printing more of it. This makes interest rates lower, as more money is easily available to both people lending money, and borrowing it. If less money is printed, this can ”˜tighten’ monetary policy and cause interest rates to rise. The government deliberately tries to ”˜manage’ the amount of money in circulation and therefore the overall economy — a difficult job, but somebody has to do it!