An interest rate is the cost representation of the premium the lender/bank is willing to collect in-turn for tying up their money with you.

Well, what does that really mean?

Interest is the premium the lender associates with the money they lend and is the profit they are willing to collect to justify the lending decision. The lender takes a risk that the borrower may not pay back the loan. Thus, interest provides a certain compensation for bearing risk. Coupled with the risk of default is the risk of inflation. When you borrow money now, the prices of goods and services may go up by the time you are paying back the loan, so your money’s original purchasing power would decrease. Thus, interest protects against future rises in inflation.

This concept is fundamentally applicable to our everyday reality, the only difference is that our decisions are on a scale that is appropriate to our lifestyle.

The government has a direct say in how interest rates are affected. The U.S. Federal Reserve (the Fed) often makes announcements about how monetary policy will affect interest rates. The Fed handles all monetary policy involving the cost of money circulating in the private sector. This includes interest rates on home loans, car loans, equity lines etc., basically consumer services that directly impact our pocket. Congress handles all fiscal policy, free of any private influence and susceptibility. These are greater indirect policies like tax rates and incentives associated with being a homeowner or parent that will impact your bottom line.

This article will emphasize the two main ways that interest rates are impacted daily. One is organic and happens on its own, the other is based on direct implementation and stimulus. Here we go…

Government Policy

The federal funds rate, or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend. That rate then eventually trickles down into other short-term lending rates. The Fed influences these rates with “open market transactions,” which is the buying or selling of previously issued U.S. securities. When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates decrease.

When the government sells securities, money from the banks is drained for the transaction, rendering fewer funds at the banks’ disposal for lending, forcing a rise in interest rates. The fed raising the rate by interpreting data and acting accordingly is the portion where there is a direct influence. The direct influence however, is actually based on involuntary circumstances & economic measures that quantify people’s spending habits.This data is indicative of what  people are willing to pay for goods,  the unemployment rate and the minimum wage. The fed vows to investment institutions that it will liquidate any mortgage note that is written with the money they borrowed from them. This creates a never-ending recycling system where money continues to be lent, recycled, and lent again. Although unconventional in nature in respects to natural economic trend, we owe our economy’s resilience and ability to bounce back from recession to the artificial life-support the economy was hooked to, in order to heal.

Supply/Demand and Inflation

If I have 10 apples, I am probably more likely to lend my friend an apple with ease, where as if I was down to my last apple, I would think twice. The decision requires less time and risk the more apples I have and the same goes for money the bank carries or allocates to lending.

An increase in the amount of money made available to borrowers increases the supply of credit. For example, when you open a bank account, you are lending money to the bank. The bank can use that money for its business and investment activities. In other words, the bank can lend out that money to other customers. The more banks can lend, the more credit is available to the economy. And as the supply of credit increases, the price of borrowing (interest) decreases.

Credit available to the economy decreases as borrowers decide to defer the repayment of their loans. For instance, when you choose 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.

When people feel more confident in the government intervention and the overall willingness of the government to participate in stimulus, as opposed to the strength of the markets and free enterprise, people are more likely to buy government bonds such as mortgage-backed securities (MBS) or invest in the Fannie Mae stock (FNMA). These securities are tied to the government stimulus and it’s something that is somewhat predictable and appealing to investors.

The opposite would be having confidence in the free market and the strengths it possesses to grow. This ideology is free of government stimulus so you would be more likely to purchase stocks of private companies like Boeing, Caterpillar, Visa and Microsoft. When money is dumped into MBS and FNMA, interest rates go down, when money is channeled away from securities and into stocks instead, the stock market rallies, sentiment on the economic outlook improves and rates start to rise.

Imagine a big seesaw with the opposite ends being these two concepts. As the seesaw becomes parallel with the floor, an equilibrium is reached. True is the same here in these circumstances. The whole point is for that seesaw to balance out where there is a moderate amount of government involvement and a moderate imbalance of consumer sentiment. Both sides are aware of what it takes to achieve this type of balance, and everyone just does the right thing. Seems a bit euphoric and farfetched I suppose, but who said analogies must be interpreted literally?

KEY TAKEAWAYS

  • An interest rate is the cost of borrowing money.
  • Interest provides a certain compensation for bearing risk.
  • Interest rate levels are a factor of the supply and demand of credit.
  • The interest rate for each different type of loan depends on the credit risk, time, tax considerations, and profitability of the loan.

In closing, as interest rates are a direct factor of income earned by lending money, of bond pricing and of the amount you will have to pay to borrow money, it is important that you understand how primary interest rates change by the forces of supply and demand, which are also affected by inflation and monetary policy. Of course, when you are deciding whether to invest in securities or considering your next refinance/purchase, it is important to understand how it’s characteristics determine what kind of interest rate you will end up with.