Interest Rates Essay

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Interest rates are the cost of borrowing money; more specifically, interest rates are the price of credit. They are sometimes defined as the “rent” on borrowed capital, or as a fee on borrowed  capital. The rates vary depending upon the risk assumed by the lender of not being repaid the capital. Interest  rates are charge in borrowing transactions. To make a loan there must be a borrower who wants to enjoy the use of the principal and a lender who is willing to risk his or her capital. The interest  rate is composed of the opportunity costs, the risks of the lender, and general economic conditions. The interest charged may be called interest, or sometimes it is masked as a fee.

One of the justifications for the charging of a fee on borrowed  capital is that  it makes up for the lost opportunities for investment  incurred  by the lender. The opportunity costs are experienced by the lender, who is compensated  by the fee that is paid for the use of the capital that must be returned. According to this line of thinking, borrowing money and paying interest on those funds is analogous to renting an automobile and paying a fee for its use.

Types And Definitions

There are several types of interest. Simple interest is calculated on the principal or on the amount that remains unpaid. It can be illustrated by drawing a rectangle with interest and principal on the side of the rectangle and the years to pay along its bottom. Then the rectangle is divided from the upper left to the lower right. The area above the  line represents  the  amount  principal  that has been paid. The area below the line is the amount of interest paid. By the end of the loan most of the payment is going for the return  of principal with most of the interest paid in the early years of the life of the loan. In effect the total amount  of interest  is calculated as a part of the total to be repaid along with the return of principal. This is different from compound  interest, which involves charging interest on interest.

Compound  interest  allows interest  to be accumulated as an addition  of the principal. It causes rapid growth in the sum of money that has to be repaid. In addition  the time periods for compounding  may be daily, weekly, or for a longer period of time. Thus, if a borrower has a loan of $1,000 and a compound  interest rate of 1 percent per week, then the loan’s balance at the end of the first week would be $1,010. Then at the end of the second week it would be 1 percent added to $1,010, which equals $1,020.10. At the end of the third week the amount would be $1,030.30. The resulting progression causes the principal to increase rapidly, making the cost of borrowing  much  higher than with simple interest.

Prior to the advent of computers  several rules of thumb  were used for calculating interest  and principal repayment schedules. One was the now outlawed “rule of 78”. Another  rough  rule is the  “rule of 72,” which  allows mental  math  by dividing the  interest rate into 72. So if the rate is 7 percent then the amount of time for the lender to double the amount  lent is 7 divided into 72 which is a little more than ten years.

Interest  rates in finance are commonly  viewed as the yield from the investment. The yield is a composite measure. It includes all payments of interest  and principal. Retail finance uses annual percentage rates and the effective annual  rate as a way of giving the consumer transparency  on the loan.

Setting Rates

Interest  rates are the result  of a number  of factors, one of which involves the concept  of deferred  consumption. If money, which is the savings accumulated by an individual or by savings institutions  is loaned, then  it is not  used by the  lender  for consumption. Instead the lender defers consumption until the loan is repaid. Part of the cost of borrowing is the price of delayed gratification by the lender.

Another  factor involved in setting interest  rates is the expectation  of inflation. The interest  rate reflects the  expectation   of  the  lender  that  the  purchasing power of the loan will over time be diminished unless it is recovered through increases in the interest rate. The loan closes the lender to other opportunities. Thus the lender is part of a process where different investments compete  for financing. It may be that a lender sees a more profitable investment but is denied the opportunity to invest because of the commitment to one loan over another.  Time is an important factor when inflation is a factor because the shorter the life of the loan, the less the principal will be affected by inflation.

Risk is another  factor affecting interest  rates. The lender  always has to  risk the  chance  of not  being repaid.  The reasons  may  be  due  to  failure  in  the investment  project. Rapidly changed economic conditions  can  ruin  the  possibility of repayment  such as a mortgage on a house that drops dramatically in value to well below the value of the loan. Financial malfeasance is also a cause of losses that can stimulate higher interest rates. Taxes can also affect interest rates as can the desire of some investors for a level of liquidity that requires high interest  rates in order to induce lenders to lend.

Interest  rates  in  the  global economy  are  set  by market forces and by governments  as a part of their monetary  policy. They factor in the rate of business activity on a macroeconomic scale. In general when interest rates are high the cost of borrowing becomes prohibitive and it dampens business activity. The reduced  investment  causes  national  income  to  fall and for slower economic  activity to mark  the  markets at that time. However, if interest rates are low the reverse happens.

In the United States the Federal Reserve (Fed) acts as a lender  to banks and charges a smaller “federal funds rate” for short-term loans than the market price of interest. The latter is the prime interest rate, which is the rate charged to the highest quality customers who have a very high capacity to repay the loan. It uses the open market  operations  as one of its monetary policy tools for guiding interest rates.

For  the  Federal  Reserve controlling  the  interest rate for the main body of money that is being lent is a way of stimulating the economy when it lowers the federal funds rate, or of dampening  inflation when it raises interest  rates. It is not at all usual for the Federal Reserve and the Congress to work at some cross purposes.  The  case  of  the  latter  fiscal policy, the spending that comes from taxation, may have a negative impact on interest rates because the goal of government spending may be to decrease unemployment with inflationary spending. The Fed is able to set rates that influence interest rates in the short run.

Interest rates are usually set competitively by market forces. They are also set in the light of lending conditions. In times of prosperity lenders compete for the business of borrowers. However, there may be times of recession or depression where the cost of lending, the interest  rates, are set high. Rates then can be set by circumstance  of need or desperation  in the financial conditions  of the borrower. A lender could then charge “whatever the traffic will bear” as the interest rate. Even in times of prosperity individuals or firms may be subject to high lending rates because of their personal on the firm’s circumstances.

Exploitation And Limits

Interest rates may be low or very high. Strictly speaking any charging of interest  is usury; however, modern economies thrive on credit financing that charges interest. To protect individuals from unscrupulous lenders, some of whom may be criminal loan sharks, many governments  have set limits on interest  rates in order  to prevent  usury. In the  United  States the states have laws that limit interest  charges on a wide variety of loans. However, the  credit  card  industry has been able to charge high interest rates that often range above twenty percent  per annum.  These rates have encountered objections  as usurious,  that  is, as excessive and exploitative. To prevent these high rates political action  is required  that  sets a lower cap on rates that is more in favor of the consumer. Some see this as an interference  with good banking; however, others  see it as exploitation  that  eventually creates economic problems.

In vast areas of the Third World rural people, and especially small farmers,  may be subjected  to  high interest rates because the only lender available is only willing to lend at high rates. The rates may be higher because of drought  or other  adverse farming conditions. The terms set by the lender could include rates that will mean the loss of the farm and the indenturing of farmers and their families. However, micro lending at low rates in many places has allowed women especially to borrow small sums to pay for such items as sewing machines.  Or the microloan  may be to purchase a farm animal such as a goat that can give milk and can be sold after breeding.

Religious Views

Historically medieval Catholic theology viewed charging interest  as usury, which was a sin because in  an  agricultural  economy  interest   charges  were seen as harmful. It was not until the advent of Protestantism  that interest  was allowed in moral theology. Protestant charging of interest followed John Calvin’s view that interest  was acceptable. He viewed renting money to be like renting land from which the produce could be used to pay the rent. This was an acceptable practice in medieval Christian  moral theology, while charging interest was not. Since Calvin was the spiritual leader of the merchants  of Geneva, they favored the practice of charging interest as renting money and as acceptable as renting a house for business or renting farm land.

Today Jews still follow biblical injunctions  to not charge their  fellow religionists  interest.  However, it may be charged on loans made to Gentiles. This practice allowed Jews in the Middle Ages to charge interest, which from the Roman Catholic point of view did not  matter,  because not  being Christians  they were considered lost souls.

Charging interest is also forbidden in Islam. There are banks run by Muslims that lend at zero interest. The banks actually take deposits and partner with the depositors  and the bankers to find projects that pay a profit. The return  from the real and carefully studied investment opportunity is seen as a profit and not as interest.  Islamic scholars usually cite Sura (Chapter) II.275-278 of the Koran as the ruling text on riba (usury). Because of the prohibition, almost all Islamic banks have survived the economic crisis of 2008.

These religious positions on the immorality of charging  interest  affect interest  rates  and  the  practice of applying interest to loans in many areas of the world. Consumer groups, aiming to protect individuals with limited incomes from predatory lenders, also seek to limit the amount of interest charged on loans. Consumer advocates have particularly agitated for government-imposed ceilings on  the  interest  rates charged by credit card companies.

Bibliography:     

  1. Daniano Brigo and Fabio Mecurio, Interest Rate Models Theory and Practice (Springer-Verlag, 2005);
  2. Delphi, Monthly Interest Amortization Tables (NTC Publishing Group, 1994);
  3. Ronald Demmel. Fiscal Policy, Public Debt and the Term Structure of Interest Rates (SpringerVerlag, 1999);
  4. Jack C. Estes, Dennis R. Kelly, and Charles Freedenberg, McGraw-Hill’s Interest Amortization Tables (McGraw-Hill Companies, 2006);
  5. Christine Helliar, Interest Rate Risk Management (Elsevier Limited, 2005);
  6. Klaas Knot, Fiscal Policy and  Interest  Rates in  the  European Union (Edward Elgar Publishing, 1996);
  7. Joel S. Moskowitz, The 16% Solution: How to Get High Interest Rates in a Low Interest World with Tax Lien Certificates, rev. ed. (Andrews  McMeel  Publishing,  2009);
  8. Richard  Sylla and Sidney  Homer,   History  of  Interest  Rates  (John  Wiley & Sons,  2005);
  9. Rudi Zagst,  Interest-Rate  Management (Springer-Verlag, 2002).

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