Interest rates receive a lot of attention in the media, but what are
they, anyway? How are they determined? What do they do? This
introduction provides some basic answers to these questions.
A. Definitions
What is Interest?
Interest
is the price that someone pays for the temporary use of someone else’s
funds. To repay a loan, a borrower has to pay interest, as well as the
principal, the amount originally borrowed.
Interest is the
compensation that someone receives for temporarily giving up the ability
to spend money. Without interest, lenders wouldn’t be willing to lend,
or to temporarily give up the ability to spend, and savers would be less
willing to defer spending.
Interest rates are expressed as
percents per year. If the interest rate is 10 percent per year, and you
borrow $100 for one year, you have to repay the $100 plus $10 in
interest.
Because interest rates are expressed simply as percents
per year, we can compare interest rates on different kinds of loans, and
even interest rates in different countries that use different
currencies (yen, dollar, etc.).
What are "APR" and "APY"?
"APR" stands for "Annual Percentage Rate," and "APY" for "Annual Percentage Yield."
The
APR includes, as a percent of the principal, not only the interest that
has to be paid on a loan, but also some other costs, particularly
"points" on a mortgage loan.
Points (a point equals one percent of
the mortgage loan amount) are fees that the mortgage lender charges for
making the loan. In a sense, points are prepaid interest, or interest
that is due when the loan is taken out.
Some lenders charge lower
interest rates but more points than other lenders. The APR therefore
provides a useful gauge for comparing the total cost of mortgage loans.
For
example, a 30-year mortgage with an interest rate of 8.0% and four
points would have an APR of 8.44%, while a mortgage with an interest
rate of 8.25% and one point would have an APR of 8.36%.
| The
principal used in calculating the APR is equal to the amount of the
loan the borrower actually has to use at any time. Consider two one-year
loans of $1,000, each with an interest rate of 10%, or $100 in
interest. |
| |
6 Months
|
12 Months
|
| LOAN #1: |
| $1,000 LOAN | |
Repay $1,000
Plus $100 Interest
|
| LOAN #2: |
| $1,000 LOAN |
Repay $500
Plus $50
Interest
|
Repay $500
Plus $50
Interest
|
|
| The
second loan has a higher APR, even though the amount of interest paid
($100) is the same on both loans. The second loan has a higher APR
because the second borrower, unlike the first borrower, does not have
the use of the entire $1,000 for the entire year, because the second
borrower repaid $500 of the loan after six months. (Another reason the
second loan has a higher APR is that the borrower paid half of the
interest after six months and half at the end of the year, rather than
all the interest at the end of the year.) |
"APY"
is the effective interest rate from the standpoint of a person
receiving interest. If you have $1,000 in each of two bank accounts,
each paying the same interest rate, but the interest is credited more
often (let’s say, every month, rather than once a year) on one of the
accounts, that account will have a higher APY, because the interest will
build up more rapidly than on the other account.
Why Does Interest Exist?
From the lender’s point of view:
- Interest
compensates lenders for the effects of inflation, or rising prices.
Prices go up every year, so lenders are repaid with dollars that can’t
buy as much as the dollars they lent; the lenders must be compensated
for that loss of purchasing power
- Interest also compensates
lenders for the risks they take. One risk is that nobody knows for
certain how much prices will go up during the time that the borrower has
the lender’s money. Other risks are that the borrower won’t repay the
loan fully, on time, or at all
- For a lender such as a bank,
interest covers the costs of staying in business, including the cost of
processing loans, and interest also provides the profit that a lender
needs to stay in business
From the borrower’s point of view:
- Individuals
are willing to pay interest to borrow money in order to be able to
spend now, rather than later, on cars and many other items
- Individuals
are willing to pay interest in order to be able to afford a large
purchase, such as a home, for which they don’t have enough funds of
their own
- Individuals are willing to pay interest on loans to pay for education, which can increase their earning ability
- Businesses
are willing to pay interest in order to borrow to invest in equipment,
buildings, and inventories that will increase their profits
- Some
borrowers are willing to pay interest on certain loans because of the
associated tax advantages. Mortgage interest, for example, is tax
deductible. That means that in calculating how much income tax you have
to pay, you can subtract the mortgage interest that you pay from your
income
- Banks are willing to pay interest on their customers’
deposits because they can lend the funds at higher interest rates and
make a profit
Interest: Cost to Some, Income to Others?
Interest
is income to people willing to give up the temporary use of their
money. When you put money into a bank account, or when you buy a U.S.
Savings Bond, for example, you receive interest income.
Interest
is a cost to borrowers. You pay interest, for example, if you don’t pay
your entire credit card bill at the end of the month, if you take out a
mortgage loan to buy a house, or if you own a business that borrows in
order to invest in machinery.
Interest is a signal that directs
funds to where they can earn the highest rates, or to where loans can do
the most for the economy.
Interest is a measure of the cost of
holding money. The rate of interest that you could earn by lending your
money is the cost to you of holding your money in a way (such as in
cash) that doesn’t earn any interest. Economists use the term
"opportunity cost" to refer to what you give up by choosing a certain
course of action. By holding money, you give up the interest that you
could have earned, so the interest rate measures the opportunity cost of
holding money.
B. The Level of Interest Rates
What Determines the Overall Level of Interest Rates -- That is, Why are Rates Higher at Some Times Than at Others?
Interest
is the price of a loan, so it is determined to a large extent by the
supply of, and demand for, credit, or loanable funds. Many different
parties contribute to the supply and demand for credit.
- When
you put money into a bank account, you are allowing the bank to lend the
funds to someone else. So, through the bank, you are contributing to
the supply of credit in the economy
- When you buy a U.S. Savings
Bond, you are lending funds to the U.S. government. Again, you are
contributing to the supply of credit
- On the other hand, when
you borrow -- to buy a car, for example, or by keeping a balance on a
credit card account -- you are contributing to the demand for credit
- Individual
savers and borrowers aren’t the only ones contributing to the supply
of, and the demand for, credit. Business firms and governments in this
country, and foreign organizations, too, affect the demand for, and
supply of, credit
Together, the actions of all of these participants in the credit market determine how high or low interest rates will be
