Simply put, an interest rate is the price you have to pay to someone in exchange for borrowing their money.
It can also be the reward you earn when you put your money in a savings account.
The interest rate is set by central banks and is used to control the economy.
In this article, you will learn about interest rates, their types, and how central banks combat inflation by tweaking this rate.
An interest rate is the amount a person charges for lending their money, usually a percentage of the total amount you want to borrow.
In other words, the borrower needs to pay back more than the borrowed amount to compensate the lender for the time they were not able to use their money.
Let’s consider bank loans. We may borrow money through bank loans for various reasons: to buy a new car, purchase a bigger house, or start our own business.
The bank usually checks our financial history or Credit Score in a way to assess our ability to pay back the loan.
A good credit score will qualify the borrower for a loan with a lower interest rate as the borrower shows the capability of repaying the borrowed amount on time and in full.
After receiving the loan, we have to pay it back in installments over a specific period of time. The failure to do so is called “Defaulting” which simply means the borrower couldn’t repay the borrowed amount.
You can also earn interest rates on your savings accounts. Savings accounts are interest-bearing bank accounts that allow you to earn money by depositing your funds for a specific period of time.
Banks use these accounts to fund the loans they offer to their customers. In other words, you become the lender and earn interest by lending your money to borrowers through your bank.
There are two types of interest rates: simple interest rates and compound interest rates.
Simple interest rates are based on the total amount of the loan or the principal.
To calculate the simple interest, you’d need to multiply the principal amount by the interest rate and the period of time you have to repay the loan.
Let’s see how it’s calculated by an example.
You are planning to get a $50,000 loan for your business. It has a 4% interest rate and you need to repay it over the period of 2 years.
The amount of the interest you would need to pay is:
In other terms, you have paid the bank the $50,000 principal amount plus $4,000 as interest at the end of the 2-year period.
Compared to simple interest rates, compound interest rates make the price of borrowing even more by taking into account both the principal and the interest from the past period.
In simple terms, the interest you have to pay during your installment payment period will increase each year. However, with the simple interest rate, the amount would stay the same in each year.
Compound interest is calculated by the following formula:
Let’s calculate the compound interest for the previous example and compare it to the simple interest:
At the end of 2 years, you have to pay $80 more in interest if your loan is based on compound interest rate.
This extra amount will increase each year, therefore, compound interest rates are much more tangible when the compounding period increases.
The Annual Percentage Rate (APR) is usually the amount you will have to pay on your loans and borrowed funds. Credit cards also have APR which may vary depending on the provider.
Annual Percentage Yield (APY), on the other hand, is the amount you will earn on your savings or investments. Savings accounts offer APY which may vary depending on the bank.
Therefore, when considering loans, you should go for a lower APR as it means your cost for borrowing is less.
On the contrary, a higher APY is a better option as it means you will earn more on your savings and investments.
However, you should always approach an unreasonably high APY with caution.
Always Do Your Own Research (DYOR) before investing and never invest more than you can afford to lose.
Central banks are mostly responsible for determining Interest rates.
Through interest rates, they can control the supply of money within the economy and can keep inflation at bay.
By managing the money supply, central banks can steer people’s spending and saving which helps them to keep inflation at a controlled level.
Commercial banks also can decide on the interest rates they offer on their loans, credit cards, and savings accounts. They usually offer different types of loans with varying interest rates.
For instance, the loan offered to a person with a high credit score will have a lower interest rate than the one offered to a borrower with a weaker credit score.
Central banks use interest rates as a tool for taming inflation.
By tweaking interest rates, monetary authorities try to incentivize market members to save or spend. In this way, they can control the capital flow in the markets and essentially handle inflation.
When the inflation rate is high in a specific market, the central bank usually increases the interest rate. Based on this rate, commercial banks can offer more APY on their savings accounts which encourages people to save their money, instead of spending.
In this scenario, the cost of borrowing has also increased. As a result, economic activities will decrease within the market, letting the prices cool off and bringing down inflation with them.
On the flip side, central banks can use interest rates to encourage people to spend more to increase economic activities within the market. This is specifically useful when the market may be going through a recession.
By decreasing interest rates, central banks make borrowing cheaper, encouraging people to borrow and spend more. As a result, spending within the market will increase, eventually leading to more jobs and economic growth.
The central banks need to control their monetary policies carefully to ensure healthy economic growth without falling into the trap of high inflation or recession.