Financial Interest Rates

By: EconomyWatch Content   Date: 4 November 2009

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Interest rates that bank and other financial institutions charge or offer customers on loans or deposits are called financial interest rates. Interest rate is the price paid to the lender by the borrower for using the money he or she does not own. Similarly, when a customer deposits his money in a bank, the bank pays a price for using the customer’s money. Interest rates are calculated in percentages, for a period of one year or a month in some cases.

Reasons for Changes in Financial Interest Rates 

Financial interest rates change, based on the demand and supply for money. Let us see some situations that lead to changes in interest rates.

Deferred Consumption: When money is loaned, the lenders delay spending on consumption goods. According to time preference theory, normally a person prefers goods now than later. This leads to rise in interest rates in a free market.

Inflationary Expectations: Most economies in the world have inflation. This means a specific amount of money can buy fewer things in the future than it can now. Thus, the borrower compensates the lender with the interest rate.

Alternative Investments: A lender has the choice to invest his money in any of the various instruments. When he chooses one, he forgoes the others. Thus, various investments compete with one another for funds.

Risks of Investment: There are always risks associated with lending. The borrower may abscond or go bankrupt or default on the loan. Here, the lender charges a risk premium to ensure that he is compensated for the loss.

Liquidity Preference: People wish to have their resources in a form which can be exchanged immediately rather than a form that takes money or time to realize.

Taxes: Lenders wish to have higher interest rates, because their gains are subject to taxes. These higher rates make up for losses related to taxation.

Fluctuations in financial interest rates can change the consumption pattern and vice versa. Interest rates on either extreme can be harmful to economies as well as individuals. To strike a balance, countries have central banks like The Fed in the US to control the supply of money.


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