Interest is the price paid to lenders for the use of their money. Interest is stated as a percentage of the amount of money borrowed. For example, a borrower who is charged 12 percent interest would pay $12 a year in interest for every $100 of the loan. Interest is based on the idea that lenders are entitled to a return on their investment. This pays them for giving up their right to use the money for a period of time or to make a profit in other ways.
Interest plays an essential part in commerce. Businesses, governments, and consumers borrow and lend money, and thus they pay and receive interest. Businesses borrow money to buy new machinery or to build new factories. They also raise money by selling bonds to the public. Investors who purchase the bonds are paid interest by the businesses that sold them. Businesses pay interest with higher earnings made possible by the borrowed money. Governments borrow to make up the difference between the money they spend and the funds they collect in taxes. A government receives interest on money it lends, such as on loans to people who want to establish a business. Consumers pay interest if they borrow to buy a home or an automobile. When people deposit money in a savings account, they are lending funds to a bank or a savings and loan association. Therefore, they receive interest.
Borrowers pay interest so they can make purchases that they could not afford if they had to pay immediately. Few people who wish to buy a house have saved enough to pay the entire cost at once. Instead of waiting until the total amount has been saved, a person can take out a mortgage from a bank or another lending institution. He or she can then live in the house while repaying the loan in monthly installments. When consumers buy goods or services on credit, they actually are borrowing money by promising to pay by a future date. If the purchase is made on a credit card, the consumer pays in monthly installments and is charged interest on the unpaid balance on the account.
Types of interest
The most common types of interest are simple, compound, and discount.
Simple interest
is paid only on the principal, the amount of money that is borrowed. A person who borrows $1,000 for two years at 10 percent simple interest would pay a total of $200 in interest. The amount of interest would be $100 (10 percent of $1,000) for the first year and $100 for the second year.
Compound interest
is computed on both the principal and the accumulated interest. A person who borrows $1,000 for two years at 10 percent interest that is compounded annually would pay a total of $210 in interest. The amount of interest would be $100 (10 percent of $1,000) at the end of the first year and $110 (10 percent of $1,100) at the end of the second year. Thus, a two-year $1,000 loan would cost $10 more at 10 percent annually compounded interest than it would at 10 percent simple interest. Interest may also be compounded at other intervals, including daily, monthly, quarterly, and semiannually.
Discount interest
is subtracted from the principal before the borrower receives the money. The amount subtracted depends on the discount rate. For example, a person who borrows $1,000 for one year at a discount rate of 10 percent would receive only $900 ($1,000 minus 10 percent). However, the borrower would have to repay the entire amount of $1,000. The borrower would pay $100 in interest for the use of only $900. With discount interest, a borrower agrees to actually pay a higher rate of interest than set forth. In the above case, the actual interest rate is 11.11 percent ($100 divided by $900).
How interest is calculated
In the United States, almost all savings establishments pay interest that is compounded daily. The two most common methods of crediting such interest are day of deposit to day of withdrawal and day of deposit to end of interest period.
Day of deposit to day of withdrawal.
This is the most common method of crediting interest, and it pays the highest amount. Suppose that you deposit $100 in a savings account one week and add $50 to the account each week for two weeks. At the end of the first week, you would have earned seven days’ interest on the original $100. In the second week, you would earn seven days’ interest on $150 plus accumulated interest. In the third week, you would earn seven days’ interest on $200 plus accumulated interest. If you withdrew some of the money from the savings account, interest would be compounded daily on the remaining amount.
Day of deposit to end of interest period.
This method involves calculating interest from the day the money is deposited until the final day of the interest period. Interest is compounded only on the amount in the account on the last day, and only for the number of days the money was in the account. Suppose you have a $300 savings account but withdraw $100 before the end of the interest period. You would receive interest on only $200 for the number of days the $200 was on deposit.
Events that cause interest rates to vary
There are a number of loan markets, including those for consumer loans, home mortgages, corporate bonds, state and local government bonds, and foreign loans. Each loan market has its own interest rate, which rises and falls over time. The interest rates in these markets, like the prices of food and other products, depend on the relationship between supply and demand. Interest rates rise if the demand for loans increases or the amount of money available for loans decreases. Generally, when interest rates are low, people are eager to borrow because loans cost less than at other times.
If either the demand for loans increases or the supply of money available for loans decreases, there will be a temporary shortage of money available for loans. This will lead to competition among people demanding loans and will drive the interest rate up. On the other hand, if either the demand for loans decreases, or the supply of money available for loans increases, a temporary surplus of money available for loans will result. This will lead to competition among suppliers of loans and will drive the interest rate down.
Supply and demand, in turn, are affected by several factors (causes). Changes in some of these factors, such as government policy, inflation, and economic activity, cause the interest rates across different loan markets to move up or down together. Other factors, such as the length of the loan and the degree of risk that a borrower may not repay, explain why interest rates are different when different borrowers apply in the same loan market.
Government policy.
Governments influence interest rates by increasing or decreasing the amount of money available for loans. A government normally does so through the nation’s central bank, which is a government agency in some countries. The Federal Reserve System, often called the Fed, is the central banking organization of the United States. The Federal Reserve System is an independent agency of the United States government. The Fed requires all United States banks to set aside a certain percentage of their deposits on reserve. The banks may use the remaining amount for loans. The Fed can influence the amount of loans commercial banks are willing to make, and thus the supply of money for loans. The Fed can do this through the monetary policy tool of open market operations (buying and selling securities, such as bonds). Other tools open to the Fed include changing the discount rate, and, although used rarely, changing the required reserve ratio. See Money (Monetary policy)
Inflation.
During a period of inflation, when prices are increasing throughout a nation’s economy, any given amount of money buys less than it did before. At such times, lenders try to protect their incomes by raising interest rates. In addition, many people are less able to save money, and so lending institutions may have less money to lend. Therefore, the amount available for loans decreases and interest rates rise. See Inflation (Monetary policy) .
Economists make a distinction between the nominal (stated) interest rate and the real interest rate. The nominal interest rate is the actual rate that is written into a loan contract. The real interest rate is the nominal rate minus the inflation rate. For example, if a car buyer borrows money at an interest rate of 7 percent, and the inflation rate is 3 percent, the real interest rate the buyer must pay back, after adjusting for the purchasing power of the dollar (inflation), is 4 percent. It is the real interest rate that reflects the true price of the loan.
Economic activity.
When the economic activity of a nation increases—that is, when consumers buy more than previously—businesses expand their production capacity. They might buy new equipment or increase the supply of raw materials they have on hand. To finance this expansion, they borrow. Therefore, the demand for loans increases and interest rates also rise. When the economy slows down—that is, when consumers buy less—businesses produce less and borrow less. Because consumers are buying less, they demand fewer loans. As the demand for loans drops, interest rates fall.
Length of a loan.
Money can be borrowed for one day or for many years. Banks often lend each other money for only a few days. However, mortgages may be issued for 20 or 30 years. Short-term loans are for a year or less. Intermediate-term loans are for one to five years, and long-term loans for longer than five years.
Interest rates for short-term loans are generally lower than rates for long-term loans for several reasons. Lenders believe they can foresee future economic conditions more accurately for a short period than a longer one. As a result, they consider short-term loans safer.
Degree of risk.
Interest rates can be influenced by the creditworthiness of the borrower—that is, the probability that the borrower will repay the loan. For example, the United States government ranks as a good credit risk. Therefore, the government can borrow at lower interest rates than many other borrowers. A company with a long record of high profits can borrow more cheaply than a company with an unproven record.
How interest rates reflect economic conditions
Certain types of interest rates reflect the general condition of the United States economy. These rates, which include the prime rate, discount rate, and federal funds rate, influence other types of interest rates.
The prime rate
is the interest rate that banks charge their best commercial customers for short-term loans. The prime rate often serves as a guide for other interest rates. Like other rates, the prime rate can vary greatly over a period of time.
The discount rate
is the rate that banks must pay when they borrow money from the Federal Reserve System. If the Federal Reserve raises its discount rate, banks tend to charge their own commercial customers higher interest rates.
The federal funds rate
is the interest rate that member banks of the Federal Reserve charge each other for short-term loans. Member banks that do not have a sufficient amount on reserve borrow from banks with a surplus. Most of these loans are made for only one day. The federal funds rate is an important indicator of the tightness or looseness of the loan market. This rate is the target of the Federal Reserve’s open market operations.
Regulation of interest rates
In the United States, the federal and state governments regulate borrowing and lending. The Consumer Credit Protection Act of 1968, often called the Truth in Lending Act, requires lenders to show borrowers the entire loan contract, including the annual percentage rate. In this way, consumers can calculate the total cost of a loan and compare the costs charged by various lenders.
The Financial Consumer Agency of Canada was founded in 2001 to oversee consumer protection for loans and other financial services for Canadians. In Australia, the Australian Securities and Investments Commission (ASIC) is responsible for consumer credit under a consumer act of 2009.
Some countries and some U.S. states have laws that limit the interest rates on certain kinds of consumer loans, such as payday loans with extremely high rates of interest. These usury laws are intended to prevent lenders from taking unfair advantage of borrowers who may be in great financial need.
History
Until the 1500’s, most people opposed the charging of interest on loans. In fact, they believed that charging interest for any reason was wrong and was the same as usury (excessive payment for the use of money).
In Biblical times, all payments for the use of money were forbidden. The Israelites considered lending money without interest to be a duty that the rich owed the poor. The ancient Greek philosopher Aristotle thought interest caused people to suffer because they needed money. During the Middle Ages (about the A.D. 400’s through the 1400’s), the Christian Church condemned the charging of interest as a sin. People found guilty of usury were whipped, deprived of their possessions, or even banished.
In 1545, King Henry VIII of England changed his nation’s laws to allow some forms of interest. By the 1700’s, charging interest had been accepted as a fair business practice. Since that time, most disagreements about interest have concerned the maximum rates that lenders should be permitted to charge.
