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Interest rates
receive a lot of attention in
the media, but what are they,
anyway? How are they determined?
What do they do? This introduction
provides some basic answers to
these questions.
Interest
is the price that someone
pays for the temporary use
of someone else’s funds.
To repay a loan, a borrower
has to pay interest, as well
as the principal, the amount
originally borrowed.
Interest is the compensation
that someone receives for
temporarily giving up the
ability to spend money.
Without
interest, lenders wouldn’t
be willing to lend, or to
temporarily give up the ability
to spend, and savers would
be less willing to defer
spending.
Interest
rates are expressed as percents
per year. If the interest
rate is 10 percent per year,
and you borrow $100 for one
year, you have to repay the
$100 plus $10 in interest.
Because interest
rates are expressed simply
as percents per year, we
can compare interest rates
on different kinds of loans,
and even interest rates in
different countries that
use different currencies
(yen, dollar, etc.).
From the
lender’s point of view:
-
Interest
compensates lenders for the
effects of inflation, or
rising prices. Prices go
up every year, so lenders
are repaid with dollars that
can’t buy as much as the
dollars they lent; the lenders
must be compensated for that
loss of purchasing power
-
Interest
also compensates lenders
for the risks they take.
One risk is that nobody knows
for certain how much prices
will go up during the time
that the borrower has the
lender’s money. Other risks
are that the borrower won’t
repay the loan fully, on
time, or at all
-
For a lender
such as a bank, interest
covers the costs of staying
in business, including the
cost of processing loans,
and interest also provides
the profit that a lender
needs to stay in business
From the borrower’s
point of view:
-
Individuals
are willing to pay interest
to borrow money in order
to be able to spend now,
rather than later, on cars
and many other items
-
Individuals
are willing to pay interest
in order to be able to afford
a large purchase, such as
a home, for which they don’t
have enough funds of their
own
-
Businesses
are willing to pay interest
in order to borrow to invest
in equipment, buildings,
and inventories that will
increase their profits
-
Some borrowers
are willing to pay interest
on certain loans because
of the associated tax advantages.
Mortgage interest, for example,
is tax deductible. That means
that in calculating how much
income tax you have to pay,
you can subtract the mortgage
interest that you pay from
your income
-
Banks are
willing to pay interest on
their customers’ deposits
because they can lend the
funds at higher interest
rates and make a profit
Regardless
of whether rates are generally
high or low, some rates are
higher than others.
The interest
rate that you pay on a car
loan typically is higher
than the interest rate that
you receive on an account
in a savings bank, for example,
and the interest rate on
a credit-card balance is
higher than the rate on a
new-car loan.
Several major
factors explain these rate
differences:
- risk
- duration
- tax considerations
- other characteristics
of a loan.
One risk
that a lender faces is that
of not being repaid. The
greater the chance that you
won’t be repaid, the higher
the interest rate you will
have to charge as compensation
for taking the risk. On the
other hand, if a loan involves
little risk, you would be
willing to accept a lower
interest rate. That’s why
the federal government can
borrow at lower rates than
can private parties. People
are sure the government will
pay its debts.
Some lenders reduce the risk
of losing what they have
lent by requiring the borrower
to pledge collateral, property
that the lender can take
possession of if the borrower
doesn’t repay the loan. The
risk is smaller in such "secured"
loans than in unsecured loans,
so the interest rates are
lower, too. Auto loans, for
example, carry lower rates
than credit-card loans, because
the lender can take possession
of the car if the borrower
fails to pay.
When you
apply for a loan, you often
have to fill out a form on
which you provide information
that the lender can use to
determine how likely you
are to be able to repay the
loan. Similarly, there are
business firms that rate
the creditworthiness of individuals,
other firms, and even governments;
lenders use this information
to determine what rates to
charge on loans.
The longer
the duration of a loan, the
more likely the lender is
to desire access to the funds.
So lenders typically have
to be compensated with higher
interest rates for parting
with their funds for longer
periods.
The longer
the duration of a loan, the
greater the uncertainty over
whether the borrower will
be able to repay the loan.
So, lenders have to be compensated
for the greater risk with
higher interest rates on
longer-term loans.
Inflation
is a major factor determining
the level of interest rates.
The longer the duration of
the loan, the greater the
risk that inflation can accelerate,
reducing the purchasing power
of the loan repayment. So,
rates generally are higher
on long-term loans than on
short-term loans, because
people who lend for longer
periods have to be compensated
for the risk that inflation
might accelerate during the
longer periods.
If you receive
interest income, you are
more concerned with how much
of the income you can keep
than with how much the borrower
pays. You are concerned with
after-tax income -- that
is, the interest you receive
minus any taxes you have
to pay on that interest.
Interest
on some types of loans has
some tax advantages. Interest
on loans to state and local
governments is exempt from
the federal income tax, and
interest on loans to the
federal government (such
as the interest you receive
on U.S. Savings Bonds) is
exempt from state and local
income taxes. These tax advantages
help governments borrow at
lower interest rates than
individuals or businesses.
When you
put money into a bank account,
you are allowing the bank
to use the money. There are
different types of bank accounts,
though, and they pay different
rates of interest. An account
that allows you to write
checks, for example, provides
you with a benefit, so it
pays a lower rate than a
savings account, which does
not offer this benefit.
If you agree
to leave your funds in a
savings account for a specified
time – two years or five
years, for example – you
are providing the bank with
some benefits. The bank knows
for certain that it will
keep your deposit, and it
knows it can use the funds
longer than if you had deposited
them in, say, a checking
account. In return, the bank
will pay you a higher rate
than on an account from which
you can withdraw your funds
at any time.
Suppose you
lend to someone and suddenly
you need the money back.
It would be advantageous
to you to be able to convert
the loan into money quickly
and without losing much of
what you have lent. Loans
that can be converted into
money quickly and without
a loss (either because you
can demand that the borrower
repay the loan at any time
or because you can sell the
loan to someone else) carry
lower rates than other loans.
Two-thirds
of U.S. households own their
own homes (as opposed to
renting), and most homeowners
pay a mortgage. Thus, the
level of mortgage rates determines
how much all these homeowners
have left to spend on other
things. How much people can
spend on other things, in
turn, affects the overall
economy.
Interest
rates on home mortgages are
important because mortgage
interest is a major item
in many people’s budgets.
Even small changes in mortgage
interest rates can have a
large impact on how affordable
it is to own a home. That’s
important, because homeownership
is the major way many families
build up wealth.
The interest
payments over the life of
a mortgage often add up to
more than the amount of the
mortgage loan. For example,
the interest payments on
a 30-year, $100,000 mortgage
at a 7% interest rate will
add up to about $140,000
over the 30 years.
People who have mortgages
may deduct the interest they
pay from their income in
calculating how much income
tax they have to pay. That’s
a significant benefit of
owning a home.
The interest rate for
a fixed-rate mortgage remains
the same for the life of
a mortgage, and the monthly
payment also stays the same
for the life of the mortgage.
For example,
a 30-year, $100,000 mortgage
at an interest rate of 7%
requires a monthly payment
of $665.30. Every month for
360 months, the payment of
principal plus interest equals
$665.30.
The vast
majority of the monthly payment
in the early years of the
mortgage is for interest,
and only a small amount reduces
the principal, the amount
of the original loan still
owed. The opposite is true
in the latter years of the
mortgage.
Therefore, most of the monthly
payment in the early years
of the mortgage is income-tax-deductible,
but very little of the payment
in the later years is deductible.
Usually, however, homeowners
will find the payments more
affordable in the latter
years, because incomes generally
rise, and inflation reduces
the "real" burden of the
fixed payment.
Refinancing — taking out
a new mortgage and paying
off your old one — may be
advisable if mortgage rates
are lower than when you took
out your mortgage.
Refinancing
involves some costs, though
— legal fees, points on the
new mortgage, and others
— so refinancing doesn’t
pay if rates have fallen
only slightly.
Experts usually advise against
refinancing unless the new
rate is at least two percentage
points lower than the rate
you’re currently paying. How long you
plan to stay in the house
is another factor to consider.
If you don’t plan to stay
in the house very long, you
may not enjoy the benefits
of the lower rate long enough
to make the costs of refinancing
worthwhile.
People sometimes refinance
their mortgages for reasons
other than to save on interest
costs. They may want to take
out a larger mortgage, for
example, in order to use
the extra cash for a major
purchase.
An adjustable-rate
mortgage has an interest
rate that moves up and down
based on changes in some
other rate, called the "index
rate." A common index rate
is the rate on a specified
U.S. Treasury security.
An ARM typically
has a lower initial interest
rate than a fixed-rate mortgage,
but the ARM rate is adjusted
periodically (perhaps every
year), based on changes in
the index rate.
Many ARMs
place a limit on how much
the interest rate can rise
in a single adjustment or
over the life of the mortgage.
Similarly, some ARMs limit
how much the monthly payment
can increase as a result
of a periodic adjustment.
That limits the risk that
the borrower will be unable
to make the payments, but
a potential problem related
to the payment cap is that
of "negative amortization,"
or an increasing mortgage
balance. That can happen
if the payment cap does not
allow the increase in the
payment to cover the increase
in the interest due each
month.
See Also
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