Interest Rate 101

You have heard of interest rates in the news (your national bank is lowering the interest rate), in advertisements for credit services , overheard colleagues speaking about their mortgage interest rates,…

But what is an interest rate? Where does it come from and how does it affect your daily finances?

An interest rate is the cost of borrowing money [source: Investopedia.com]. In other words see this as a fee to pay your bank for them providing a certain amount of cash today, instead of you saving up during a few months or years.

As you know interest rates are expressed in percent, e.g. 5%, this represents an annual fraction of the amount borrowed (as well called the principal). this means that if you borrow 100 USD from the bank today and the bank charges you a 5% annual rate, at the end of the year you will owe 105 USD.

Clear so far?

Now, what will define whether the bank will charge you 5%,4% or 7% of interest rate? If you are participating in a quiz, hit the buzzer and say with full confidence :”I have read it lately on an awesome Blog and the answer is RISK!”. Let us put ourselves in the shoes of the banker and say you have 2 persons coming to you to ask for a loan of 100 USD, Jean-Claude and Sarah.  Jean-Claude has a well-paid job, lives large but often too large so that his account is negative at the end of the month on a regular basis while Sarah also has a well-paid job but lives within her means. Who would you trust is more likely to pay you your 100 USD back? You agree that Sarah´s spending habits represent less risk than Jean-Claude´s, right? So what we will do to balance our risk of never seeing our money back is to charge a higher interest rate to Jean-Claude.

If you have asked for a loan to a bank or other financial institution you have probably heard of the credit score or credit check. The better the credit score, the more confidence the bank will have in you reimbursing the borrowed amount. So if you earn 30 000 USD annually and you spend 24 000 USD, the bank will be more likely to give you a better interest rate (read a lower fee for borrowing money) than if you earn 80 000 USD annually and spend 82 000 USD. You get the picture?

The same reasoning can apply when you will feel confident in investing in a project (be it stocks, real estate, cars, wine,…), you will as in the bank example expect a higher return for a start-up (you do not know today how it will perform) than if you will invest in for example US government bonds (the US government has not defaulted yet so the risk is low).

Now you understand the basics of interest rates, let´s take it up a notch and talk about the central banks and their role in defining the market interest rate. In Europe we have the ECB (European Central Bank) and in the US we have the Fed (Federal Reserve Bank), to keep it simple these large institutions are the banks of commercial banks, their role is to control the money supply and the stability of prices by defining the interest rates in their respective economies. In Europe at the moment the interest rate defined by the Central European Bank is at 0,25%[Source : ECB* official website] and in the US the rate defined by the Fed is at 0,5% [source : Global rates]. These rates define at which rate the commercial banks can borrow money to them. In turn the commercial banks will (should) adjust the interest rates they charge to individual borrowers. If you pay a visit to the websites you will see that the interest rates are historically low as they have been lowered by the central banks in recent months, as such that means that this is a good time to invest! And the more people will invest, the more the economy will grow! So why and when should the central bank increase its rates?

Let us assume that the interest rates are so low that many of us borrow to the bank, the economy is growing at a fast pace but one side effect is that this naturally lead to inflation (rise of price of goods and service), one example might be that there are simply not enough homes for the amount of borrowers so the housing price increase naturally. A response of the central bank could be to increase the interest rates to slow down the cash entry and maintain a reasonable inflation rate (typically 2-3% annual rate)

The goal of this article was to introduce you to the interest rates in a simple manner and show how understanding the basics can already give you a step ahead in understanding how the economy works! Let me know if you want it explained differently or in a clearer way.

*Fun fact : Peter Praet one of the members of the Executive Board was actually one of my teachers at uni.

 

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