How Do Interest Rates Work

How Do Interest Rates Work? ● The amount a lender charges a borrower is called an interest rate, and it is expressed as a percentage of the principle, or the lent amount. ● Typically, a loan's interest rate is expressed as an annual percentage rate, or APR (APR). ● A savings account or certificate of deposit earnings with a bank or credit union may also be subject to an interest rate (CD). ● The interest received on these bank accounts is measured in annual percentage yields (APY). ● The amount that a lender charges a borrower for the use of assets on top of the principle is known as the interest rate. ● The money generated from a deposit account at a bank or credit union is likewise subject to an interest rate. ● Most mortgages use simple interest. ● However, some loans use compound interest, which is applied to the principal but also to the accumulated interest of previous periods. ● A borrower that is considered low risk by the lender will have a lower interest rate. ● A loan that is considered high risk will have a higher interest rate. ● The APY is the interest rate that is earned at a bank or credit union from a savings account or CD. Savings accounts and CDs use compounded interest. Knowledge of Interest Rates ● In essence, interest is a fee assessed to the borrower for the use of a resource. Borrowed assets may include money, merchandise, automobiles, and real estate. ● Since higher interest rates make borrowing the same amount of money more costly, they can be seen as the "cost of money." ● The majority of loan and borrowing transactions thus include interest rates. ● People take out loans to buy houses, finance initiatives, start or fund enterprises, or cover college tuition. ● Businesses get loans to finance capital projects and grow their business by acquiring long-term and fixed assets like real estate, buildings, and equipment. ● The repayment of borrowed funds might be made in one lump sum by a specific date or over the course of several payments. ● The principle, or total amount of the loan, is what is used to calculate the interest rate for loans. The cost of debt for the borrower and the rate of return for the lender are represented by the interest rate. Since lenders demand payment for the loss of use of the money during the loan period, the amount due is typically more than the amount borrowed. Instead of making a loan at that time, the lender may have made investments with the money, which would have brought in income from the asset. The amount of interest charged is the difference between the final payback amount and the original loan. ● Borrowers are typically assessed a reduced interest rate when the lender deems them to be a low risk. If the borrower is considered high risk, the interest rate that they are charged will be higher, which results in a higher cost loan. Rate of Simple Interest ● If you borrow $300,000 from a bank and the loan agreement specifies that the interest rate is 4 percent simple interest, you will be required to repay the bank the initial loan amount of $300,000 + (4 percent x $300,000) = $300,000 + $12,000 = $312,000 as well as the additional $12,000 fee. ● The formula for calculating yearly simple interest, which was used to calculate the example above, is: ○ Principal times Interest Rate Times Time Equals Simple Interest ● If the loan was just for a year, the person who took it out will have to pay $12,000 in interest at the end of the year. ● The interest payment would be as follows if the loan's length were 30 years: Simple interest = $300,000 X 4% X 30 = $360,000 ● A simple interest rate of 4% annually translates into an annual interest payment of $12,000. ● After 30 years, the borrower would have made $12,000 x 30 years = $360,000 in interest payments, which explains how banks make their money. Rate of Compound Interest ● Compound interest is preferred by some lenders, which results in increased interest payments from the borrower. ● Both the principal and the accrued interest from earlier periods are affected by compound interest, also known as interest on interest. ● The bank expects that the borrower will still owe the whole principle amount plus interest after the first year. ● The bank also anticipates that the borrower will still be responsible for paying the principle, interest from the previous year, and interest on interest from the previous year at the conclusion of the second year. ● When interest is compounded, it is due more than when interest is calculated simply. ● The interest is charged monthly on the principal including accrued interest from the previous months. ● For shorter time frames, the calculation of interest will be similar for both methods. ● As the lending time increases, however, the disparity between the two types of interest calculations grows. Accounts with compound interest and savings ● Compound interest works in your benefit when utilizing a savings account to save money. ● The compounded interest collected on these accounts is given to the account holder as payment for consenting to the bank's usage of the deposited cash. ● The bank can take $300,000 of your $500,000 investment into a high-yield savings account and utilize it as a home loan. ● The bank will reimburse you by adding one percent interest each year to the account. Therefore, the bank earns 3 percent in interest while collecting 4 percent from the borrower and paying 1 percent to the account holder. ● In essence, savers give money to the bank, which then lends it to borrowers in exchange for interest. Cost of Debt to the Borrower ● Although interest rates are a source of income for the lender, they are a cost of borrowing for the borrower. ● Versus evaluate which source of funding will be the least expensive, businesses compare the cost of borrowing to the cost of equity, such as dividend payments. ● The cost of the capital is assessed to create the ideal capital structure since the majority of businesses finance their capital through the issuance of stock or the assumption of debt. APY versus APR ● Consumer loan interest rates are often expressed as an annual percentage rate (APR) (APR). ● For the right to borrow their money, lenders need a certain rate of return. An APR is used, for instance, to quote credit card interest rates. ● The APR for the mortgage or borrower in the aforementioned scenario is 4 percent. Compound interest for the year is not taken into account by the APR. ● The interest rate received on a savings account or certificate of deposit (CD) at a bank or credit union is known as the annual percentage yield (APY). Compounding is taken into consideration in this interest rate. What Factors Determine Interest Rates? ● The status of the economy is one of several variables that affect the interest rate that banks charge. ● The interest rate is determined by the central bank of a nation (the Federal Reserve in the U.S., for example), and each bank utilizes that rate to determine the range of APRs they provide. ● The cost of debt increases when the central bank sets interest rates at a high level. ● High interest rates deter consumers from taking on debt and reduce consumer demand. Additionally, inflation tends to increase interest rates. ● Banks may increase reserve requirements, the money supply may become constrained, or credit demand may increase in an effort to counteract inflation. ● People save their money in a high-interest economy because they get more from the savings rate. ● Since investors would choose to take advantage of the higher rate on savings than participate in the stock market with lesser returns, the stock market loses. ● Additionally, businesses have restricted access to capital investment through debt, which results in a slowdown in the economy. ● Because borrowers have access to loans at cheap rates, economies are frequently boosted during periods of low interest rates. ● Low interest rates on savings make it more probable for firms and people to spend money and buy riskier investments like stocks. ● This spending stimulates the economy and gives the capital markets a boost, which promotes economic growth. ● Although governments favor lower interest rates, these rates eventually cause market disequilibrium when supply outweighs demand, which results in inflation. ● Interest rates rise in an inflationary environment, which may be related to Walras' law. Discrimination and Interest Rates ● Systemic racism still exists in the US despite regulations like the Equal Credit Opportunity Act (ECOA) that forbid discriminatory lending practices. ● According to a Realtor.com analysis released in July 2020, mortgage rates are higher for purchasers in predominantly Black neighborhoods than they are for buyers in white regions. ● Its examination of mortgage data from 2018 and 2019 revealed that the increased rates resulted in an additional approximately $10,000 in interest charges over the course of a typical 30-year fixed-rate loan. ● The Consumer Financial Protection Bureau (CFPB), which upholds the ECOA, published a Request for Information in July 2020, inviting feedback from the public to help identify ways to strengthen the ECOA's efforts to guarantee nondiscriminatory access to credit. ● African Americans and other minorities are protected by clear rules, but the CFPB must back them up with action to make sure lenders and others follow the law,” stated Kathleen L. Kraninger, director of the agency. Why Do 30-Year Loan Interest Rates Compare to 15-Year Loan Interest Rates? ● Interest rates depend on opportunity cost and default risk. Loans and obligations with longer maturities are inherently riskier since the borrower has a larger window of opportunity to fail. While the primary is locked up and cannot be utilized for any other purpose over the longer time periods, the opportunity cost is higher during those times. ● What Economic Purpose Does the Fed Serve with Interest Rates? ● Interest rates are a tool used by the Federal Reserve and other central banks across the world to implement monetary policy. ● The central bank may affect many other interest rates, such as those on personal loans, corporate loans, and mortgages, by raising the cost of borrowing among commercial banks. ● This makes borrowing more expensive in general, lowering the demand for money and cooling off a hot economy. ● Lowering interest rates, on the other hand, makes money easier to borrow, stimulating spending and investment. Why Do Bond Prices React Oppositely to Changes in Interest Rates? ● A bond is a type of financial instrument that normally pays a set interest rate throughout the course of its existence. ● Let's say the current interest rate is 5%. ● A bond with a par value of $1,000 and an interest rate (coupon) of 5% will pay bondholders $50 annually. If interest rates increase to 10%, newly issued bonds will pay out twice as much, or $100 for every $1,000 in face value. ● Existing bonds that only pay $50 must be sold at a significant discount in order for someone to be interested in purchasing them. ● Likewise, new bonds will only pay $10 per $1,000 in face value if interest rates fall to 1%. Consequently, a $50 bond will be in high demand and its price will be bid up quite high.