What are interest rates?
Interest rates are growth rates. They are expressed as a percentage, typically on an annual basis, that is used to calculate how much a loan or investment, costs or grows, over time.
Interest rates are most commonly associated with borrowing money, like a homeowner taking out a mortgage or a government selling a bond. The interest rate is an extra charge, on top of the principal, that needs to be paid back in exchange for access to the asset, (e.g. cash, property, vehicles etc.). Interest rates are also used in savings accounts, where you might earn interest on your savings.
For example, if you spent $100 on a credit card with an 24% annual interest rate, and waited one month to pay it back, you would need to pay the $100, plus the interest for one month. That would $102, (24% divided by 12 months, or 2%).
Nominal vs Real Interest Rates
Interest rates are usually fixed, but a dollar today is not worth the same as a dollar a year from now. The nominal interest rate is the rate of interest before adjusting for inflation, and it represents the actual gain or loss of money (expressed in percentages) obtained by an investor or paid by a borrower. The real interest rate, on the other hand, represents the actual purchasing power gained or lost by an investor or a borrower. For this reason, in economics we almost always use the real interest rate.
To calculate the real interest rate, subtract the inflation rate from the nominal interest rate.
If you have a savings account that pays 2% annual interest (meaning a 2% nominal interest rate), but the inflation rate was 3%, your real interest rate is -1%. You’re actually losing value!
When you choose to save your money in a bank account and not utilize it, you are giving up the time value of that money. The interest rate exists to compensate you for the value that you lose. If the interest rate you’re earning on your savings is too low, or if it’s below the inflation rate, you may end up with a negative real interest rate, which means that you lose money because the inflation rate is eroding the purchasing power of the money you saved. In such cases, people may look for other investment opportunities, such as stocks or government bonds, where they can earn a positive real interest rate.
Using The Real Interest Rate
Using the real interest rate lets you calculate the future value of any investment or loan you make. Conversely, by using the inverse of the real interest rate, you can take any future value and convert it into the present value.
This means that you can use interest rates to see how money travels through time. Saving is effectively fast-forwarding your money to the future for later consumption, while borrowing is taking money from your future self for consumption now.
When you choose to save, you can use the real interest rate to see how much your savings will be worth in the future. If the future value of your savings makes it worth the wait, you will save the money. If not, you will consume today.
The same is true when you borrow, if you decide that the present value of how much you need to pay back is less than you think it’s worth, you’ll take the loan. If not, you would pass.
What makes interest rates increase or decrease?
Interest rates can increase or decrease based on a variety of factors such as inflation, economic growth, government policies, and global events. The business cycle, which is the natural, cyclical pattern of economic expansion and contraction, affects interest rates because it determines the level of demand for borrowing and lending. The central banks also use interest rates as a tool for controlling the economy during the business cycle, raising and lowering interest rates to regulate activity.
Loan Risk
When a loan is considered risky, the lender will charge a higher interest rate to compensate for the higher likelihood of default. In contrast, reliable borrowers are often offered lower interest rates as they pose less of a risk. This concept is essential to understand when it comes to investments.
For instance, government bonds tend to have very low interest rates because there is a low risk that the borrower will default. Conversely, stocks have the potential for substantial returns, but they present greater risk, including the possibility of losing value.
Many Borrowers or Savers
Supply and demand can significantly affect interest rates. When there is a high demand for loans and borrowing, lenders can charge higher interest rates to capitalize on the market needs. On the other hand, when there is a surplus of funds available for lending, lenders will lower interest rates to attract the borrowers. Central banks can react by adjusting interest rates to influence the dynamics of supply and demand, aiming for economic stability.
Expected Inflation
Expected inflation can impact interest rates significantly. Inflation erodes the purchasing power of money over time. When there are expectations of higher inflation, lenders may demand higher interest rates to offset the anticipated loss in value caused by inflation.
Look at it this way, if your friend asks to borrow $100 for a year, expected inflation may affect your decision on what interest rate to charge them. If you expect an increase in inflation over the coming year, you may want to charge a higher interest rate to compensate for the loss in the value of their repayment.
What do high interest rates mean?
At the end of the day, when real interest rates are high across the economy, it means that a lot of people and businesses are borrowing money. This means that there is a general shift from saving to spending, and the allocation of resources over time has shifted from the future to the present (as a total economy, we are borrowing money from our future selves).
Higher interest rates mean that it’s getting more expensive to borrow, which encourages people to save more. This shifts the balance of resources back to the future, and causes interest rates to fall in the long-term.
In the short-term, higher interest rates makes it more expensive to borrow money. Meaning that individuals and businesses will be spending less on large purchases, like buying new equipment or a new house.
Very high interest rates can discourage individuals and businesses from taking out loans altogether, increasing the likelihood of default on existing loans, and possibly creating a liquidity crisis in the financial markets. The government and central banks often intervene to moderate interest rates to prevent such disasters as hyperinflation and widespread economic hardship.
Overall, very high interest rates can indicate a troubled economy with reduced investment opportunities and consumer confidence, dampening the economy’s performance. Rising interest rates are typically a result of economic growth, while falling interest rates are typically a symptom of an economic slowdown.