Everybody is a borrower and a lender in today’s economy. Every time a person taps, swipes, or inserts their credit card, they are borrowing money from a credit lender, even if it is just short-term. Depositing money into your savings account or buying guaranteed investment certificates (GICs), is a way of lending money to the bank. In each transaction, interest is involved. But what is interest exactly, and how does it work?
What is Interest?
Interest is either what you pay when you borrow somebody else’s money, or what you receive when you lend your own money to somebody else. It is an extra charge that is added to most borrowed money, and is usually calculated over time, so the longer it takes to repay a loan, the more interest will be added.
There are three main factors to calculate interest: the interest rate, the principal amount (original amount borrowed), and how long it will take to repay the loan. If you have agreed to a higher rate of interest or a longer-term loan, you will end up paying more.
What Are Interest Rates?
An interest rate is the price for loanable money. The rate is established according to the supply of available funds from lenders, and the demand for those funds by borrowers.
Interest rates play an integral role in the national economy as they affect the money supply and credit markets. Therefore, they can have a positive effect or a negative one. High rates make borrowing more expensive and can deter consumers or businesses from applying for loans. Low rates make borrowing cheaper, but they can discourage consumers from depositing funds in the bank.
In the U.S., the Federal Reserve establishes the guiding rate through the fed funds rate. This is what banks charge each other for overnight loans. Generally, the federal government and the central bank prefer low interest rates. The fed funds rate has been below the 2% mark for most of the 21st century, a measure taken to fuel economic growth.
How Does Interest Work in Credit Markets?
Knowing how interest works begins with understanding the two main categories: simple and compound.
Simple interest is the rate on the total original amount the borrower must repay. The compound is interest on the principal and the accrued interest – interest on interest.
You might also come across something called APR, which stands for annual percentage rate. The APR starts with the interest rate, followed by one-time fees and any additional charges (broker fees and closing costs). The APR essentially conveys the total cost of a loan over its length.
For lenders, several factors go into deciding how much interest is charged and what kind. Some important aspects would include projected inflation, credit risk, and liquidity (how much cash the borrower has).
Borrowers then need to assess other interest elements, particularly the fixed-rate and the variable. A fixed-rate interest is an unchanged rate charged on a loan or a debt through the life of the liability, while a variable rate changes based on movements of financial markets. Moreover, borrowers need to consider the many types of interest for different products. For example, credit cards will have an APR or a daily periodic rate (DPR), which is the APR divided by 365.
Who Should Determine Interest?
Critics will argue that the free market should determine interest rates because it is impossible for a central authority to know what the precise figure should be. It is comparable to prices; a bureaucrat could never understand the correct cost of a grain of rice or a carton of milk. Until the Federal Reserve gets out of the business of rate-fixing, it is important to pay attention to its announcements to grasp the present and future rate of interest – as a consumer, investor, borrower, or lender.