Interest Rates Explained

TL;DR

It doesn’t make much sense to lend money for free. If Alice wants to borrow $10,000 from Bob, Bob will need a financial incentive to loan it to her. That incentive comes in the form of interest – a kind of fee that gets added on top of the amount Alice borrows.

Interest rates profoundly impact the broader economy, as raising or lowering them greatly affects people’s behavior. Broadly speaking:

• Higher interest rates make it attractive to save money because banks pay you more for storing your money with them. It’s less attractive to borrow money because you need to pay higher amounts on the credit you take out.
• Lower interest rates make it attractive to borrow and spend money – your money doesn’t make much by sitting idle. What’s more, you don’t need to pay huge amounts on top of what you borrow.

Introduction

As we’ve seen in How Does the Economy Work?, credit plays a vital role in the global economy. In essence, it’s a lubricant for financial transactions – individuals can leverage capital that they don’t have available and repay it at a later date. Businesses can use credit to purchase resources, use those resources to turn a profit, then pay the lender. A consumer can take out a loan to purchase goods, then return the loan in smaller increments over time.

Of course, there needs to be a financial incentive for a lender to offer credit in the first place. Often, they’ll charge interest. In this article, we’ll take a dive into interest rates and how they work.

What is an interest rate?

Interest is a payment owed to a lender by a borrower. If Alice borrows money from Bob, Bob might say you can have this $10,000, but it comes with 5% interest. What that means is that Alice will need to pay back the original $10,000 (the principal) plus 5% of that sum by the end of the period. Her total repayment to Bob is, therefore, $10,500.

So, an interest rate is a percentage of interest owed per period. If it’s 5% per year, then Alice would owe $10,500 in the first year. From there, you might have:

• a simple interest rate – subsequent years incur 5% of the principal

or 

• a compounded interest rate – 5% of the $10,500 in the first year, then 5% of $10,500 + $525 = $11,025 in the second year, and so on.

Why are interest rates important?

Unless you transact exclusively in cryptocurrencies, cash, and gold coins, interest rates affect you, like most others. Even if you somehow found a way to pay for everything in Dogecoin, you’d still feel their effects because of their significance within the economy.

Take a commercial bank – their whole business model (fractional reserve banking) revolves around borrowing and lending money. When you deposit money, you’re acting as a lender. You receive interest from the bank because they lend your funds to other people. In contrast, when you borrow money, you pay interest to the bank.

Commercial banks don’t have much flexibility when it comes to setting the interest rates – that’s up to entities called central banks. Think of the US Federal Reserve, the People’s Bank of China, or the Bank of England. Their job is to tinker with the economy to keep it healthy. One function they perform to these ends is raising or lowering interest rates.

Think about it: if interest rates are high, then you’ll receive more interest for loaning your money. On the flip side, it’ll be more expensive for you to borrow, since you’ll owe more. Conversely, it isn’t very profitable to lend when interest rates are low, but it becomes attractive to borrow.

Ultimately, these measures control the behavior of consumers. Lowering interest rates is generally done to stimulate spending in times when it has slowed, as it encourages individuals and businesses to borrow. Then, with more credit available, they’ll hopefully go and spend it.

Lowering interest rates might be a good short-term move to rejuvenate the economy, but it also causes inflation. There’s more credit available, but the amount of resources remains the same. In other words, the demand for goods increases, but the supply doesn’t. Naturally, prices begin to rise until an equilibrium is reached.

At that point, high interest rates can serve as a countermeasure. Setting them high cuts the amount of circulating credit, since everyone begins to repay their debts. Because banks offer generous rates at this stage, individuals will instead save their money to earn interest. With less demand for goods, inflation decreases – but economic growth slows.

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What is a negative interest rate?

Often, economists and pundits speak of negative interest rates. As you can imagine, these are sub-zero rates that require you to pay to lend money – or even to store it at a bank. By extension, it makes it costly for banks to lend. Indeed, it even makes it costly to save.

This may seem like an insane concept. After all, the lender is the one assuming the risk that the borrower may not repay the loan. Why should they pay? 

This is perhaps why negative interest rates are something of a last resort to fix struggling economies. The idea comes from a fear that individuals may prefer to hold onto their money during an economic downturn, preferring to wait until it recovers to engage in any economic activity. 

When rates are negative, this behavior doesn’t make sense – borrowing and spending appear to be the most sensible choices. This is why negative interest rates are considered to be a valid measure by some, under extraordinary economic conditions.

Closing thoughts

On the surface, interest rates appear to be a relatively straightforward concept to grasp. 

Nevertheless, they’re an integral part of modern economies – as we’ve seen, adjusting them can fundamentally alter the behavior of individuals and businesses. This is why central banks take such a proactive role in using them to keep nations’ economies on track.