interest
rates
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
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
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,
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