Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds.
An interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they borrow from a lender (creditor). Specifically, the interest rate (I/m) is a percent of principal (P) paid a certain amount of times (m) per period (usually quoted per annum). For example, a small company borrows capital from a bank to buy new assets for its business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to the borrower. Interest rates are normally expressed as a percentage of the principal for a period of one year
REASONS WHY INTEREST RATES CHANGES
- Political short-term gain: Lowering interest rates can give the economy a short-run boost. Under normal conditions, most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. The quick boost can influence elections. Most economists advocate independent central banks to limit the influence of politics on interest rates.
- Deferred consumption: When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate.
- Inflationary expectations: Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this.
- Alternative investments: The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds.
- Risks of investment: There is always a risk that the borrower will go bankrupt, abscond, die, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.
- Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time to realize.
- Taxes: Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.
Few businesses are able to make major purchases without taking out loans. Businesses must pay interest, a percentage of the amount loaned, to whoever loans them the money, whether loans are for vehicles, buildings, or other business needs.
Some businesses loan their own money and receive interest payments as income. In fact, a savings account can be considered a type of loan because by placing your money in the account, you’re giving the bank the opportunity to loan that money to others. So the bank pays you for the use of your money by paying interest, which is a type of income for your company.
The financial institution that has your money will likely combine your money with that of other depositors and loan it out to other people to make more interest than it’s paying you. That’s why when the interest rates you have to pay on loans are low, the interest rates you can earn on savings are even lower.
Banks actually use two types of interest calculations:
· Simple interest is calculated only on the principal amount of the loan.
· Compound interest is calculated on the principal and on interest earned.
Simple interest is simple to calculate. Here’s the formula for calculating simple interest:
Principal × interest rate × n = interest
To show you how interest is calculated, assume that someone deposited $10,000 in the bank in a money market account earning 3 percent (0.03) interest for 3 years. So, the interest earned over 3 years is $10,000 × .03 × 3 = $900.
Compound interest is computed on both the principal and any interest earned. You must calculate the interest each year and add it to the balance before you can calculate the next year’s interest payment, which will be based on both the principal and interest earned.
Here’s how you would calculate compound interest:
Principal × interest rate = interest for Year One
(Principal + interest earned) × interest rate = interest for Year Two
(Principal + interest earned) × interest rate = interest for Year Three
You repeat this calculation for all years of the deposit or loan. The one exception could be with a loan. If you pay the total interest due each month or year (depending on when your payments are due), there would be no interest to compound.
When working with large sums or high interest rates for long periods of time, compound interest can make a big difference in how much you earn or how much you pay on a loan.
Ideally, you want to find a savings account, certificate deposit, or other savings instrument that earns compound interest. But, if you want to borrow money, look for a simple interest loan.
Not all accounts that earn compound interest are created equally. Watch carefully to see how frequently the interest is compounded. If you can find an account where interest is compounded monthly, the interest you earn will be even higher.
Monthly compounding means that interest earned will be calculated each month and added to the principle each month before calculating the next month’s interest, which results in a lot more interest than a bank that compounds interest just once a year.
Market interest rates
There is a market for investments which ultimately includes the money market, bond market, stock market, and currency market as well as retail financial institutions like banks.
Exactly how these markets function are sometimes complicated. However, economists generally agree that the interest rates yielded by any investment take into account:
- The risk-free cost of capital
- Inflationary expectations
- The level of risk in the investment
- The costs of the transaction
This rate incorporates the deferred consumption and alternative investments elements of interest
Real vs nominal interest rates
Further information: Fisher equation
The nominal interest rate is the amount, in percentage terms, of interest payable.
For example, suppose a household deposits $100 with a bank for 1 year and they receive interest of $10. At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per annum.
The real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account.
If inflation in the economy has been 10% in the year, then the $110 in the account at the end of the year buys the same amount as the $100 did a year ago. The real interest rate, in this case, is zero.
After the fact, the 'realized' real interest rate, which has actually occurred, is given by the Fisher equation,