An interest rate is the cost of borrowing money. Or, on the other side of the coin, it is the compensation for the service and risk of lending money. In both cases it keeps the economy moving by encouraging people to borrow, to lend and to spend.
//Low interest rates, better to borrow and spend.
high interest rates, want to borrow less. instead want to store and invest to earn the high interest rates.//
Lenders and Borrowers
Lender: Lend $x now, get the $x money back in 10 years, purchasing power of $x could have decreased when you got the money back due to inflation. Thus, interest protects against future rises in inflation.
A lender such as bank uses the interest to process account costs as well.
Borrowers: pay interest because they must pay a price for gaining the ability to spend now, instead of having to wait years to save up enough money. Businesses also borrow for future profit. They may borrow now to buy equipment so they can begin earning those revenues today. Banks borrow to increase their activities, whether lending or investing and pay interest to clients for this service.
Interest can thus be considered a cost for one entity and income for another. It can represent the lost opportunity or opportunity cost of keeping your money as cash under your mattress as opposed to lending it. And if you borrow money, the interest you have to pay could be less than the cost of forgoing the opportunity of having access to the money in the present.
How Interest Rates are Determined
Supply and Demand
Interest rate levels are a factor of the supply and demand of credit.
Increase in the demand/ decrease in supply of money or credit –> increases interest rates
Decrease in the demand/ increase in supply of money or credit –> decreases interest rates
Inflation will also affect interest rate levels. The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they will be repaid in the future.
The government has a say in how interest rates are affected. The U.S. Federal Reserve (the Fed) often makes announcements about how monetary policy will affect interest rates.
The federal funds rate, or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend. That rate then eventually trickles down into other short-term lending rates. The Fed influences these rates with “open market transactions,” which is basically the buying or selling of previously issued U.S. securities. When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates decrease. When the government sells securities, money from the banks is drained for the transaction, rendering fewer funds at the banks’ disposal for lending, forcing a rise in interest rates.
Types of Loans
Of the factors detailed above, supply and demand are, as we implied earlier, the primary forces behind interest rate levels. The interest rate for each different type of loan, however, depends on the credit risk, time, tax considerations (particularly in the U.S.) and convertibility of the particular loan.
Risk refers to the likelihood of the loan being repaid. A greater chance that the loan will not be repaid leads to higher interest rate levels.
For government-issued debt securities, there is of course very little risk because the borrower is the government. For this reason, and because the interest is tax-free, the rate on treasury securities tends to be relatively low.
Time is also a factor of risk. Long-term loans have a greater chance of not being repaid because there is more time for adversity that leads to default.
The Bottom Line
As interest rates are a major factor of the income you can earn by lending money, of bond pricing and of the amount you will have to pay to borrow money, it is important that you understand how prevailing interest rates change: primarily by the forces of supply and demand, which are also affected by inflation and monetary policy. Of course, when you are deciding whether to invest in a debt security, it is important to understand how its characteristics determine what kind of interest rate you can receive.