Imagine a scenario where someone living in Houston, Texas, in the United States goes to the nearest JP Morgan Chase branch in search of a loan and meets the requirements to get it. If you aren’t familiar with banking, the only way this is possible is if they agreed to all conditions set, and among them would be the interest rates.
This is a very important aspect of banking in general and covers quite a lot according to Rates. So, how does one define interest rates, and what are they all about? Let’s delve into the world of Rates interest and see the details that surround it.
Table of Contents
A look at the basics
One defines interest rates as the additional amount one has to pay along with the agreed principal as a condition for borrowing money from an institution. This usually presents itself as the additional amount that’s paid every year in what is known as the annual percentage rate or APR. The term also refers to what one earns from an institution if they have a savings account. It is from these, that you would earn the annual percentage yield or the APY.
You can actually imagine interest rates as the price tag on a loan or the extra fee you get for lending money. It’s like that little extra that comes with the deal. So if you decide to borrow money, whether it’s for a new car or your dream house, the interest rate determines how much more you’ll need to pay back over time. One can think of it as a small fee for the borrowing option.
Why do we need them anyway?
The reason for interest to be paid is that it is simply the price or cost of debt one pays for borrowing money. Because that money would otherwise be used for something else, it has to be paid for, which explains why what you pay back is considerably more than what you got.
What determines them?
The rate is determined by whether someone asking for a loan is of high risk. If so, the interest will be higher and the opposite is true for lower risks. Determining this requires a look at a few key factors which are listed below:
- Credit score
- The ability to repay
- The available collateral
- The terms and conditions
Main types to check
As the heading implies, there are two types of interest rates, each with its calculation method attached to it. These two are as follows:
- Simple variety
- Compound variety
The former of the two is calculated when a fixed percentage of the principle is then multiplied by it and the time. It is from this that you can tell the total amount. The latter of the two is also a fixed percentage but applies to not only the principle but the accumulated interest, which is why it’s also known as interest on interest.
Calculating compound interest is a bit more complicated, but lenders often go this route because it means more interest to get. Usually, they use the principal amount P (let us make it $500) and apply the formula A = P(1 + r/n)^(nt). In this formula, r stands for the interest rate (for example, let’s take 6%), n is the number of compounding periods/year and t is the time period in years (let’s make it 2 years). So A represents the final/future amount which will be 572.47 dollars. Interestingly enough, those with saving accounts of the high-yielding variety also partake in the process as lenders.
What’s the source?
After a closer look, it’s pretty clear to see that the above is a fairly detailed look at interest rates and how they work. However, that’s only half of the story with a large omission being placed on the origins of interest rates and their journey from the central banks to the average borrower.
Interest rates at their core are influenced by a country’s central bank. Well, over 200 central banks out there including the US Federal Reserve determine this based on several things, chief of which is the present economic state. With that in mind, the Federal Reserve would set the uniform rate all financial institutions are to use when forming their APRs. The past year saw the US interest rates peak at 9.1% and drop since.
At this macro level, central banks could raise rates to do the same for the cost of debt, which helps in times of high inflation. When rates are low, however, there’s a lot more financial activity across the board because the cost of debt is lower and allows borrowers to buy necessities and take part in the trade.
While it is ideal for the Fed to have lower interest rates, when this happens for too long, inflation is bound to happen. In response, the Fed will have no choice but to raise the rates to a point where a state of equilibrium is reached.
Further necessary knowledge
Being as vast a subject as this area of business is, many tend to overlook an abundance of things. So, before entertaining the idea of borrowing in any capacity, keep the points below in mind to maintain a level of certainty:
- Loans repaid over a long period come with higher rates so as to provide the lender more money and to deal with the risk;
- The stock market is often affected as higher rates discourage investors, who take advantage of savings instead;
- Central banks can also impact mortgages;
- The movement of rates in either direction always impacts bond prices in an inverse manner.
Having come to terms with the information above, one easily sees the vastness and detailed nature of interest rates. A more intimate look shows how regular people monitor rates to see whether or not applying for and receiving loans is a possibility, which similarly applies to large enterprises.
A wider vantage point reveals how the Fed and other global equivalents use said rates as a bit of a prune in the economy. In any case, it’s pretty safe to say that this part of the financial world is beyond important.