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What is Interest and Who Decides the Rate of It?

May 25th, 2011

We hear talk about current interest rates on a daily basis. We’re told that they’re at a historical low, and that they’re due to rise in the near future. But many people may not know what the actual purpose of interest rates are in the first place, and what it is that determines them.

In the article “Forces Behind Interest Rates,” Reem Heakal explains just that.

What is Interest?

Interest is the cost of borrowing money. In a sense, lending money is a service. Therefore, it requires a fee, or there would be no incentive to lend. When you put your money in a saving account, you acquire interest over time. That’s because you’re ultimately lending your money to the bank, and the bank can lend it to other customers.

But, maybe more appropriately, interest is the cost of the risk involved in lending money. When someone borrows money from you, there’s also that chance that he or she won’t pay you back. Interest, then, is compensation for taking that risk, similarly to insurance.

Interest also covers the risk of inflation. The value of money, or its purchasing power, is relative to the cost of goods. As Heakal explains, “When you lend money now, the prices of goods and services may go up by the time you are paid back your money, whose original purchasing power would have decreased. Thus, interest protects against future rises in inflation.”

What Determines Interest Rates?

Supply and Demand. Interest rates, or the amount of interest you pay, is decided in part by the demand for credit, and the amount of credit that’s available. If the demand for credit increases while the supply decreases, then interest rates will rise.

There are many factors that determine the supply of credit, but individual consumers do play a part, as Heakal points out:

Credit available to the economy is decreased as lenders decide to defer the re-payment of their loans. For instance, when you decide to postpone paying this month’s credit card bill until next month or even later, you are not only increasing the amount of interest you will have to pay, but also decreasing the amount of credit available in the market. This in turn will increase the interest rates in the economy.

Inflation. High inflation refers to the increase cost of goods and services in an economy over time. The higher the rate of inflation, the higher the rate of interest because the money has more purchasing power when it’s first lent than it will once it’s paid back, as costs continue to grow. Interest helps to counter inflation but ensuring that the value of the money repaid is relatively equal to the value of the money lent.

Government. The U.S. Federal Reserve controls how much money is in the market by buying and selling previously issued U.S. securities. Heakal explains:

When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates then decrease. When the government sells securities, money from the banks is drained for the transaction, rendering less funds at the banks’ disposal for lending, forcing a rise in interest rates.

Acadia Lending Group LLC

190 Riverside Street Unit 4B
Portland , Maine 04103

Phone: 207-899-4500

Fax: 207-899-4503

NMLS: 370636

 

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