According to Wikipedia, interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum) 1. It is the cost of borrowing money or the return on saving money 23. Interest rates can vary depending on the product and the borrower, and they can also apply to different types of transactions, such as loans, savings accounts, credit cards, bonds, and certificates of deposit (CDs).
Types of Interest Rates
There are different types of interest rates that can be applied to different situations. Some of the common types are:
- Nominal interest rate: This is the interest rate that is stated on a loan or deposit agreement. It does not take into account inflation, compounding, fees, or taxes. For example, if a loan has a nominal interest rate of 10% per year, it means that the borrower pays $10 in interest for every $100 borrowed per year.
- Real interest rate: This is the interest rate that adjusts for inflation and reflects the true purchasing power of money. It is calculated by subtracting the inflation rate from the nominal interest rate. For example, if a loan has a nominal interest rate of 10% per year and the inflation rate is 3% per year, the real interest rate is 7% per year.
- Effective interest rate: This is the interest rate that takes into account compounding, which is the process of adding interest to the principal and then calculating interest on the new balance. It is calculated by using a formula that depends on the frequency of compounding. For example, if a loan has a nominal interest rate of 10% per year compounded monthly, the effective interest rate is 10.47% per year.
- Annual percentage rate (APR): This is the interest rate that takes into account fees and other charges associated with a loan or credit card. It is calculated by dividing the total cost of borrowing by the amount borrowed and multiplying by 100. For example, if a loan has a nominal interest rate of 10% per year and charges $50 in fees for a $1000 loan, the APR is 15% per year.
- Annual percentage yield (APY): This is the interest rate that takes into account compounding and reflects the amount earned from a savings account or CD. It is calculated by using a formula that depends on the frequency of compounding. For example, if a savings account has a nominal interest rate of 5% per year compounded monthly, the APY is 5.12% per year.
Factors Affecting Interest Rates
Interest rates are determined by various factors that influence the supply and demand of money in the market. Some of the main factors are:
- The central bank: The central bank is the institution that controls the money supply and sets the base or policy interest rate for the economy. The central bank can raise or lower the base rate to influence other interest rates in the market and achieve its monetary policy goals, such as price stability and economic growth. For example, in the United States, the Federal Reserve sets the federal funds rate, which is the interest rate that banks charge each other for overnight loans.
- The market expectations: The market expectations are the beliefs and forecasts of investors and consumers about future economic conditions and events. The market expectations can affect interest rates by influencing the demand and supply of money and credit in the market. For example, if investors expect higher inflation in the future, they may demand higher interest rates to lend money or invest in bonds.
- The risk premium: The risk premium is the additional amount of interest that lenders charge borrowers to compensate for the possibility of default or loss. The risk premium can vary depending on the creditworthiness of the borrower, the duration of the loan, and the collateral or security offered by the borrower. For example, if a borrower has a low credit score or a long-term loan, they may have to pay a higher risk premium than a borrower with a high credit score or a short-term loan.
- The time preference: The time preference is the preference of people to have money now rather than later. The time preference can affect interest rates by influencing how much people are willing to save or borrow money at a given point in time. For example, if people have a high time preference, they may prefer to spend money now rather than save it for later, which may increase the demand for money and credit and raise interest rates.
Effects of Interest Rates
Interest rates have various effects on different sectors of the economy and society. Some of the main effects are:
- On consumption and investment: Interest rates affect consumption and investment by influencing how much people are willing to spend or save money. Generally, lower interest rates encourage consumption and investment by making borrowing cheaper and saving less attractive, while higher interest rates discourage consumption and investment by making borrowing more expensive and saving more attractive.
- On inflation and growth: Interest rates affect inflation and growth by influencing the aggregate demand and supply of goods and services in the economy. Generally, lower interest rates stimulate aggregate demand and increase inflation and growth, while higher interest rates dampen aggregate demand and reduce inflation and growth.
- On exchange rates and trade: Interest rates affect exchange rates and trade by influencing the demand and supply of foreign currency in the market. Generally, higher interest rates attract foreign capital inflows and appreciate the domestic currency, while lower interest rates deter foreign capital inflows and depreciate the domestic currency. This in turn affects the competitiveness of exports and imports in the international market.
Conclusion
Interest rates are important indicators of the cost and return of money in the market. They are determined by various factors that influence the supply and demand of money and credit in the market. They have various effects on different sectors of the economy and society, such as consumption, investment, inflation, growth, exchange rates, and trade.
References
2: What Is an Interest Rate? | U.S. News
3: Interest Rates: Different Types and What They Mean to Borrowers
4: Interest rate Definition & Meaning | Dictionary.com
5: Interest rate financial definition of interest rate – Financial Dictionary