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.
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.
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.
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