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Interest rates change due to fluctuations in the supply and demand of credit. When demand for credit is high or when supply of credit is low, interest rates tend to rise. When demand for credit is low or supply of credit is high, interest rates tend to fall. Other important factors that influence interest rates include the rate of inflation and government monetary policy.
Prevailing interest rates are always changing, and different types of loans offer different interest rates. If you are a lender, a borrower, or both, it’s important you understand the reasons for these changes and differences.​
Key Takeaways
- Interest provides lenders with certain compensation for bearing risk.
- Interest rates fluctuate based on the supply and demand of credit.
- Other influential factors include inflation and government monetary policy.
- The interest rate for different types of loans depends on the credit risk, timing, tax considerations, and convertibility of the particular loan.
Lenders and Borrowers
Simply put, interest rates reflect the cost of borrowing money.
When a loan is issued, the lender is taking on a risk that the borrower may not pay it back. Thus, interest provides a certain compensation for bearing risk. Coupled with the risk of default is the risk of inflation. Since one lends money in the present, and the prices of goods and services may go up by the time one is paid back, the money’s original purchasing power might decrease. Thus, interest protects against future rises in inflation. A lender, such as a bank, uses the interest to process account costs as well.
Borrowers pay interest because they must pay a price for gaining the ability to spend now, instead of having to wait years to save up enough money. For example, a person or family may take out a mortgage for a house for which they cannot presently pay in full, but the loan allows them to become homeowners now instead of far into the future.
Businesses also borrow for future profit. They may borrow now to buy equipment so they can begin earning those revenues today. Banks borrow to increase their activities, whether lending or investing, and pay interest to clients for this service.Â
Interest can thus be considered a cost for one entity and income for another. It can represent the lost opportunity or opportunity cost of keeping your money as cash under your mattress as opposed to lending it. And if you borrow money, the interest you have to pay could be less than the cost of forgoing the opportunity of having access to the money in the present.
How Interest Rates are Determined
Supply and Demand
An increase in the demand for money or credit will raise interest rates, while a decrease in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.
An increase in the amount of money made available to borrowers increases the supply of credit. For example, when you open a bank account, you are lending money to the bank. Depending on the kind of account you open, the bank can use that money for its business and investment activities. In other words, the bank can lend out that money to other customers. The more banks can lend, the more credit is available to the economy. And as the supply of credit increases, the price of borrowing (interest) decreases.
Credit available to the economy decreases as borrowers decide to defer the repayment of their loans. For instance, when you choose to postpone paying this month’s credit card bill until next month or even later, you are not only increasing the amount of interest you will have to pay but also decreasing the amount of credit available in the market. This, in turn, can increase the interest rates in the economy.
Inflation
Inflation can also affect interest rates. The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they are paid in the future.
Government
The government has a say in how interest rates are affected. The U.S. Federal Reserve (the Fed) often makes announcements about how monetary policy will affect interest rates.
The federal funds rate, or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend. That rate then eventually trickles down into other short-term lending rates. The Fed influences these rates with “open market transactions,” which is the buying or selling of previously issued U.S. securities. When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates decrease. When the government sells securities, money from the banks is drained for the transaction, rendering fewer funds at the banks’ disposal for lending, forcing a rise in interest rates.
Interest keeps the economy moving by encouraging people to borrow, to lend, and to spend.
Types of Loans
Of the factors detailed above, supply and demand are, as we implied earlier, the primary forces behind interest rate levels. The interest rate for each different type of loan, however, depends on the credit risk, time, tax considerations (particularly in the U.S.), and convertibility of the particular loan.
Risk refers to the likelihood of the loan being repaid. A greater chance that the loan will not be repaid leads to higher interest rate levels. If, however, the loan is “secured,” meaning there is some sort of collateral that the lender will acquire in case the loan is not paid back (i.e., such as a car or a house), the rate of interest will probably be lower. This is because the risk factor is accounted for by the collateral.
For government-issued debt securities, there is, of course, minimal risk because the borrower is the government. For this reason, and because the interest is tax-free, the rate on treasury securities tends to be relatively low.
Time is also a factor of risk. Long-term loans have a greater chance of not being repaid because there is more time for the adversity that leads to default. Also, the face value of a long-term loan, compared to that of a short-term loan, is more vulnerable to the effects of inflation. Therefore, the longer the borrower has to repay the loan, the more interest the lender should receive.
Finally, some loans that can be converted back into money quickly will have little if any loss on the principal loaned out. These loans usually carry relatively lower interest rates.
Is APR the Same As Interest Rate?
A common acronym that you may come across when considering interest is APR, which stands for “annual percentage rate.” This measure includes interest costs, but is also a bit more broad. In general, APR reflects the total cost of borrowing money. It includes interest, but may also include other costs including fees and charges, as applicable.
How Can Higher Interest Rates Affect the Economy?
Interest rates can affect the economy in a number of ways. Three of the most evident are that they increase the cost of borrowing for individuals, potentially reducing spending; they increase the cost of borrowing for businesses, potentially reducing investment; and they can tighten the money supply, which can reduce inflation.
What Does It Mean if the Fed Cuts Rates?
When the Federal Reserve makes a rate cut, it changes the interest rate at which banks lend to each other overnight. Such moves typically have implications for the rest of the economy. In general, when the Fed cuts rates, interest rates tend to decline. This can benefit those who are keen to spend, such as prospective homebuyers, but can hurt those who are trying to save, such as those opening savings accounts or certificates of deposit.
The Bottom Line
Interest rates are influenced by a range of factors. Primarily, they fluctuate based on the demand and supply of credit. When demand for credit is high or supply is low, interest rates typically rise. When demand for credit is low and supply is high, interest rates typically fall. Other factors include inflation and monetary policy.