Interest rates are the amount that a borrower pays for to a lender in order to use capital for a specific period of time. Interest rate is also known as the cost of borrowing assets. Interest rates are expressed in terms of annual percentages on the amount that is borrowed or on that portion of the borrowed amount that remains unpaid.
Who Determines Interest Rates?
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.
Factors That Affect Interest Rates
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.
Types of 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.
Key Interest Rate Facts
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.
The subject of interest rates is broad and complex, and is vitally important to every economy's consumer and commercial success.
Credit Card Interest Rates
Credit card interest rates are fees paid by credit card customers in return for borrowing money from banks or credit card companies.
Central Bank Interest Rates
Central bank interest rates are the rates a nation's central bank charges to banks to lend money. In the US, the central bank is called the Federal Reserve, or Fed, and there are 12 Federal Reserve Banks there.
Money Market Interest Rates
Money market interst rates are rates paid by banks in return for the money deposited with them by retail or commercial customers.
Get detailed on the various interest rate types before you decide on a savings account or credit card.