Schluessel

What Is Interest Rate?

An interest rate is the percentage charged by a lender to a borrower for the use of assets, or the percentage paid on a deposit by a financial institution to a saver. It is fundamentally the cost of borrowing money or the return on lending money, expressed as a percentage of the principal amount. Interest rates are a core component of macroeconomics and significantly influence monetary policy decisions. The level of an interest rate impacts everything from consumer loans and mortgages to economic growth and inflation.

History and Origin

The concept of charging interest on borrowed money dates back millennia, with evidence found in ancient Sumerian texts around 3000 BCE. Early forms of interest were often paid in agricultural goods or labor. The modern understanding and widespread application of interest rates as a tool for economic management gained prominence with the rise of central banking.

A significant historical period demonstrating the powerful impact of interest rates was the "Volcker Shock" in the United States. In the late 1970s, the U.S. economy faced rampant inflation, reaching double digits. Paul Volcker, then Chairman of the Federal Reserve, implemented stringent measures in October 1979, dramatically raising the federal funds rate to unprecedented levels, peaking around 20% by June 1981. This aggressive tightening of monetary policy was aimed at curbing inflation by making borrowing significantly more expensive and reducing the money supply. While it led to two recessions in 1980 and 1981-1982, Volcker's actions successfully brought inflation under control and are widely regarded as a pivotal moment in U.S. economic policy, restoring the Federal Reserve's credibility.⁸, ⁹

Key Takeaways

• An interest rate is the cost of borrowing or the return on saving, expressed as a percentage of the principal.
• Central banks use interest rates as a primary tool to influence economic growth and control inflation.
• Higher interest rates typically discourage borrowing and encourage saving, potentially slowing economic activity.
• Lower interest rates tend to stimulate borrowing and spending, aiming to boost economic expansion.
• Interest rates affect various financial products, including bonds, loans, and savings accounts.

Formula and Calculation

The calculation of interest can be either simple or compound.

Simple Interest Formula:
Simple interest is calculated only on the principal amount.

Where:

• (I) = Interest amount
• (P) = Principal amount (initial investment or loan amount)
• (R) = Annual interest rate (as a decimal)
• (T) = Time (in years)

Compound Interest Formula:
Compound interest is calculated on the initial principal and also on the accumulated interest of previous periods.

Where:

• (A) = Amount after time T (future value)
• (P) = Principal amount (initial investment or loan amount)
• (R) = Annual nominal interest rate (as a decimal)
• (N) = Number of times that interest is compounded per year
• (T) = Time (in years)

To find the interest amount, subtract the principal from the amount after time T: (I = A - P). The concept of future value and present value are intrinsically linked to compound interest calculations.

Interpreting the Interest Rate

Interpreting an interest rate involves understanding its implications for borrowers, savers, and the broader economy. A higher interest rate means a greater cost for borrowing, which can deter individuals from taking out new loans for homes or cars, and businesses from expanding. Conversely, it offers a higher return for savers and investors in fixed-income instruments. A lower interest rate environment makes borrowing cheaper, potentially stimulating consumer spending and business investment.

The interest rate set by central banks, such as the Federal Funds Rate in the U.S., serves as a benchmark for other rates in the economy. Financial market participants also closely watch the yield curve, which plots the interest rates of bonds with different maturities, as it can signal expectations for future economic conditions.

Hypothetical Example

Consider Sarah, who wants to take out a $10,000 personal loan.

• Scenario A: Low Interest Rate. Her bank offers a loan with an annual interest rate of 4% compounded annually for 3 years.

  $$A = 10,000 \left(1 + \frac{0.04}{1}\right)^{(1 \times 3)}$$ $$A = 10,000 \times (1.04)^3$$ $$A = 10,000 \times 1.124864$$ $$A = 11,248.64$$

  The total interest paid would be (11,248.64 - 10,000 = $1,248.64).

• Scenario B: High Interest Rate. Another lender offers the same loan at an annual interest rate of 10% compounded annually for 3 years.

  $$A = 10,000 \left(1 + \frac{0.10}{1}\right)^{(1 \times 3)}$$ $$A = 10,000 \times (1.10)^3$$ $$A = 10,000 \times 1.331$$ $$A = 13,310.00$$

  The total interest paid would be (13,310.00 - 10,000 = $3,310.00).

This example illustrates how a higher interest rate significantly increases the overall cost of borrowing, impacting Sarah's financial burden.

Practical Applications

Interest rates are a ubiquitous factor in the financial world, influencing decisions across various sectors.

• Monetary Policy: Central banks primarily use interest rates (like the Discount Rate or the federal funds rate) to implement monetary policy. By adjusting these rates, they aim to control inflation, foster full employment, and ensure financial stability. For instance, the International Monetary Fund (IMF) has noted that global central banks have implemented significant interest rate increases to combat inflation, with the potential for rates to remain "higher for longer" in some economies.⁶, ⁷
• Lending and Borrowing: From individual mortgages and car loans to corporate financing, interest rates dictate the cost of debt. Higher rates make borrowing more expensive, potentially cooling demand, while lower rates can stimulate it. For example, Reuters has published explainers on how higher interest rates directly impact personal finances, affecting everything from credit card rates to auto loans.⁴, ⁵
• Investment Decisions: Interest rates directly affect the valuation of bonds and other fixed-income securities. They also influence equity markets, as borrowing costs for companies and the discount rate used in valuing future earnings change.
• Savings and Deposits: Individuals earning interest on savings accounts or certificates of deposit (CDs) benefit from higher interest rates, which increase their returns.
• International Finance: Interest rate differentials between countries can influence capital flows and exchange rates. Higher rates in one country might attract foreign investment, strengthening its currency.

Limitations and Criticisms

While interest rates are a potent tool for economic management, they face several limitations and criticisms:

• Zero Lower Bound (ZLB): A significant limitation, especially for monetary policy, is the zero lower bound on nominal interest rates. Once policy rates hit or approach zero, a central bank's ability to provide further stimulus through traditional rate cuts becomes constrained. This was notably observed during the 2008 financial crisis and the COVID-19 pandemic. The Federal Reserve Bank of San Francisco has discussed how the zero lower bound poses a medium-term risk, impacting the effectiveness of policy at longer horizons due to increased uncertainty.¹, ², ³
• Time Lags: Changes in interest rates do not immediately affect the economy. There are often significant and variable lags between a rate change and its full impact on inflation and economic growth, making precise policy timing challenging.
• Unintended Consequences: Aggressive interest rate hikes, while effective against inflation, can lead to recessions and increased unemployment. Conversely, prolonged low interest rates can contribute to asset bubbles or excessive risk-taking in financial markets.
• Effectiveness in Different Economic Regimes: The impact of interest rates can vary depending on the economic environment. For instance, in a liquidity trap, where individuals hoard cash and banks hold excess reserves, traditional interest rate policy may become less effective.
• Moral Hazard: Persistently low interest rates can create moral hazard by encouraging excessive borrowing and discouraging prudent financial management among individuals and firms.

Interest Rate vs. Yield

While often used interchangeably by the public, "interest rate" and "yield" have distinct meanings in finance, particularly when discussing bonds and other fixed-income securities.

An interest rate on a bond, also known as its coupon rate, is set when the bond is issued and remains constant. However, the bond's yield to maturity, which is the total return anticipated on a bond if it is held until it matures, changes daily with the bond's market price. When a bond's price goes down, its yield goes up, providing a higher return to new buyers relative to the face value. Conversely, if the bond's price increases, its yield decreases.

FAQs

How do interest rates affect my mortgage?

Interest rates directly impact the cost of your mortgage. A higher interest rate means higher monthly payments and a larger total amount paid over the life of the loan. Conversely, lower rates make homeownership more affordable by reducing these costs. For adjustable-rate mortgages (ARMs), your interest rate can change periodically, affecting your payments.

Why do central banks change interest rates?

Central banks adjust interest rates primarily to achieve their monetary policy objectives, which typically include maintaining price stability (controlling inflation) and promoting maximum sustainable economic growth and employment. Raising rates aims to cool down an overheating economy and curb inflation, while lowering rates seeks to stimulate economic activity during a slowdown.

What is a "good" interest rate?

What constitutes a "good" interest rate depends entirely on whether you are borrowing or saving, and the prevailing economic conditions. For borrowers, a lower interest rate is generally considered "good" as it reduces the cost of their loans. For savers and investors, a higher interest rate is "good" as it means a greater return on their deposits or investments.

How does the Federal Reserve influence interest rates?

The Federal Reserve, as the U.S. central bank, primarily influences interest rates through its target for the federal funds rate, which is the rate at which banks lend reserves to each other overnight. By adjusting this target, the Fed influences other short-term rates, which then ripple through the economy to affect longer-term rates like those on mortgages and corporate bonds.