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Information and description:
An interest rate is the price a borrower pays for the use of money he does not own, and the return a lender receives for deferring his consumption, by lending to the borrower. Interest rates are normally expressed as a percentage over the period of one year.
Interest rates are also a vital tool of monetary policy and are used to control variables like investment, inflation, and unemployment.
Causes of interest rates
• Deferred consumption. When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive intreest rate.
• Inflationary expectations. Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this.
• Alternative investments. The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds.
• Risks of investment. There is always a risk that the borrower will go bankrupt, abscond, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.
• Liquidity preference. People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realise.
There is a market for investments which ultimately includes the money market, bond market, stock market and currency market as well as retail financial institutions like banks.
Exactly how these markets function is a complex question. However, economists generally agree that the interest rates yielded by any investment take into account:
• The risk-free cost of capital
• Inflationary expectations
• The level of risk in the investment
• The costs of the transaction
Risk
The level of risk in investments is taken into consideration. This is why very volatile investments like shares and junk bonds have higher returns than safer ones like bank deposits.
The extra interest charged on a risky investment is the risk premium. The required risk premium is dependent on the risk preferences of the lender.
If an investment is 50% likely to go bankrupt, a risk-neutral lender will require their returns to double. So for an investment normally returning $100 they would require $200 back. A risk-averse lender would require more than $200 back and a risk-loving lender less than $200. Evidence suggests that most lenders are in fact risk-averse.
Generally speaking a longer-term investment carries a maturity risk premium, because long-term loans are exposed to more risk of default during their duration.
Interest rate notations
What is commonly referred to as the interest rate in the media is generally the rate offered on overnight deposits by the Central Bank or other authority, annualised.
The total interest on an investment depends on the timescale the interest is calculated on, because interst paid may be compounded.
In finance, the effective interest rate is often derived from the yield, a composite measure which takes into account all payments of interest and capital from the investment.
In retail finance, the annual percentage rate and effective annual nterest rate concepts have been introduced to help consumers easily compare different products with different interset payment structures.
See
also:
• Interest rate
nominal interest rate
Effective annual rate
• Adverse Credit History
• Annual percentage rate
• Credit Score
•
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This
article is licensed under the GNU
Free Documentation License.
It uses material from the Wikipedia
article "Interest Rate".
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