An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, the compounding frequency, and the length of time over which it is lent, deposited or borrowed.
It is defined as the proportion of an amount loaned which a lender charges as interest to the borrower, normally expressed as an annual percentage.
It is the rate a bank or other lender charges to borrow its money, or the rate a bank pays its savers for keeping money in an account.
Annual interest rate is the rate over a period of one year. Other interest rates apply over different periods, such as a month or a day, but they are usually annualised.
Interest rates vary according to:
the government’s directives to the central bank to accomplish the government’s goals
the currency of the principal sum lent or borrowed
the term to maturity of the investment
the perceived default probability of the borrower
supply and demand in the market
as well as other factors.
A company borrows capital from a bank to buy assets for its business. In return, the bank charges the company interest. (The lender might also require rights over the new assets as collateral.)
Base rate usually refers to the annualized rate offered on overnight deposits by the central bank or other monetary authority.
Annual percentage rate (APR) and effective annual rate or annual equivalent rate (AER) are used to help consumers compare products with different payment structures on a common basis.
A discount rate is applied to calculate present value.
For an interest-bearing security, coupon rate is the ratio of the annual coupon amount (the coupon paid per year) per unit of par value, whereas current yield is the ratio of the annual coupon divided by its current market price. Yield to maturity is a bond’s expected internal rate of return, assuming it will be held to maturity, that is, the discount rate which equates all remaining cash flows to the investor (all remaining coupons and repayment of the par value at maturity) with the current market price.
Interest rate targets are a vital tool of monetary policy and are taken into account when dealing with variables like investment, inflation, and unemployment. The central banks of countries generally tend to reduce interest rates when they wish to increase investment and consumption in the country’s economy. However, a low interest rate as a macro-economic policy can be risky and may lead to the creation of an economic bubble, in which large amounts of investments are poured into the real-estate market and stock market. In developed economies, interest-rate adjustments are thus made to keep inflation within a target range for the health of economic activities or cap the interest rate concurrently with economic growth to safeguard economic momentum.
Germany experienced deposit interest rates from 14% in 1969 down to almost 2% in 2003
In the past two centuries, interest rates have been variously set either by national governments or central banks. For example, the Federal Reserve federal funds rate in the United States has varied between about 0.25% to 19% from 1954 to 2008, while the Bank of England base rate varied between 0.5% and 15% from 1989 to 2009, and Germany experienced rates close to 90% in the 1920s down to about 2% in the 2000s. During an attempt to tackle spiraling hyperinflation in 2007, the Central Bank of Zimbabwe increased interest rates for borrowing to 800%.
The interest rates on prime credits in the late 1970s and early 1980s were far higher than had been recorded – higher than previous US peaks since 1800, than British peaks since 1700, or than Dutch peaks since 1600; «since modern capital markets came into existence, there have never been such high long-term rates» as in this period.
Possibly before modern capital markets, there have been some accounts that savings deposits could achieve an annual return of at least 25% and up to as high as 50%. (William Ellis and Richard Dawes, «Lessons on the Phenomenon of Industrial Life… «, 1857, p III–IV)
Reasons for changes
Political short-term gain: Lowering interest rates can give the economy a short-run boost. Under normal conditions, most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. The quick boost can influence elections. Most economists advocate independent central banks to limit the influence of politics on interest rates.
Deferred consumption: When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate.
Inflationary expectations: Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this.
Alternative investments: The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds.
Risks of investment: There is always a risk that the borrower will go bankrupt, abscond, die, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.
Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time to realize.
Taxes: Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.
Banks: Banks can tend to change the interest rate to either slow down or speed up economy growth. This involves either raising interest rates to slow the economy down, or lowering interest rates to promote economic growth.
Economy: Interest rates can fluctuate according to the status of the economy. It will generally be found that if the economy is strong then the interest rates will be high, if the economy is weak the interest rates will be low.
Some economists like Karl Marx argue that interest rates are not actually set purely by market competition. Rather they argue that interest rates are ultimately set in line with social customs and legal institutions. Karl Marx writes:
«Customs, juristic tradition, etc., have as much to do with determining the average rate of interest as competition itself, in so far as it exists not merely as an average, but rather as actual magnitude. In many law disputes, where interest has to be calculated, an average rate of interest has to be assumed as the legal rate. If we inquire further as to why the limits of a mean rate of interest cannot be deduced from general laws, we find the answer lies simply in the nature of interest.»
Real vs nominal
Main article: real versus nominal value (economics)
Further information: Fisher equation
The nominal interest rate is the rate of interest with no adjustment for inflation.
For example, suppose someone deposits $100 with a bank for 1 year, and they receive interest of $10 (before tax), so at the end of the year, their balance is $110 (before tax). In this case, regardless of the rate of inflation, the nominal interest rate is 10% per annum (before tax).
The real interest rate measures the growth in real value of the loan plus interest, taking inflation into account. The repayment of principal plus interest is measured in real terms compared against the buying power of the amount at the time it was borrowed, lent, deposited or invested.
If inflation is 10%, then the $110 in the account at the end of the year has the same purchasing power (that is, buys the same amount) as the $100 had a year ago. The real interest rate is zero in this case.