In countries with centralized banking systems, the rate of interest is determined by the central bank or a federal bank. A country’s economists observe the prevailing financial conditions before they make recommendations. Accordingly, the country’s central bank devises a national interest rate policy that governs interest rates pertaining to lending and borrowing throughout the nation.
Interest rates are usually determined by the forces of demand and supply. Here are some factors that financial institutions or lenders consider when they determine interest rates for a specific amount:
Opportunity cost: This is the profit that a lender can earn, if the loan amount had been invested elsewhere.
Inflation: The rate of inflation impacts interest rates because every lender wants returns from the loan to reflect the reduced purchasing power. Lenders usually add the existing or expected inflation value to the interest rates to avoid losses. Alternatively, lenders can also charge market-driven interest rates that correspond with changes in the rate of inflation.
Default: There is always a probability of borrowers declaring bankruptcy. They can also abscond or default on loan repayment. So, this aspect impacts interest rates too.
Loan duration: In short-term loans, it is possible to predict risk factors and inflation rates to a certain extent but not for long term loans. Long term loans are difficult to estimate because the lender has to incorporate all possible risks to estimate the future value of the loan amount. A lender’s priority would be to remain profitable. So, it results in formulating higher interest rates.
Simple interest is calculated on the principal amount or the amount left unpaid.
Compound interest differs from simple interest in two ways. Firstly, compound interest can be calculated annually, semiannually, quarterly or continuously. Next, the unpaid interest earned is added to the unpaid amount to obtain principal amount for the next period.
Interest rates are charges paid or received for borrowing or lending money.
Interest rates are expressed as a percentage of the sum in question, and vary depending on the product (credit card, certificate of deposit, savings, house loan, car loan, interbank loan, etc), the economic climate and conditions, political situation, monetary policy, fiscal policy, legislation, and more.
Interest rates are key drivers in any free-market economy. The lower the central bank rates, the easier money flows between banks and ultimately to consumers.
Interest rates directly contribute to consumer activity in that the higher they are for bank savings account and certificate of deposits (CDs) the more the consumers will save. The same is true for Treasury Bills, or T-Bills, which are guaranteed US government bonds.
Interest rates drive consumer spending and lending in the credit card sector as well, although less-so than elsewhere.
Lower credit card interest rates mean more people will apply for credit cards, facilitating more consumer stimulus and spending. Note that high interest rates never stopped consumers from using their credit cards, however.
Interest rates, in the form of T-Bills also play a role in foreign investment. China has a trillion or more US dollars invested in the US, and if the T-Bill rates suddenly dropped and China pulled their money out, the US would suffer unimaginable financial turmoil.