Interest Rates Complete Guide – Definition, Details & Examples
Interest rates are the percentage of principal charged by the lender for the use of its money. The principal is the amount of money loaned, while the interest amount represents the bank’s profit from lending money or assets. Interest is the cost of borrowing money. So interest rates show how those borrowing costs will accumulate over time. For example, if you take a loan from a bank with an annual interest rate of 5%, after 12 months, you will have paid the principal monthly payments+ 5% of the original principal.
What is Interest?
Interest is the rent of money. We can think of interest as a kind of rent. It is the rent you demand when you give your money to someone else for a while, just as you demand when you rent out your house. The most commonly used interest types are loan and deposit interest. The interest rate plays an essential role in determining the course of the economy.
Interest is the amount that the lender or institution charges for using financial assets, expressed as a percentage of the principal. In other words, we can say that it is the amount charged to the borrower over the principal for the use of the lender’s assets. Financial assets in question include cash, real estate, cars, consumer goods, etc. can be found.
Factors such as inflation determine interest rates in a country. The interest rate applied to financial assets accepted as low risk is lower, and the interest rate for high-risk assets is higher. Interest rates affect the cost of loans. Interest rates in a country also affect the investment decisions of capital. Central banks try to maintain economic stability by intervening in interest rates. For example, in the USA, the FED manages interest rates to maintain current financial strength and keep the economy growing.
How Interest Rates Work
Suppose a saver has $10,000 in savings and wants to deposit that money into a bank account. He expects to use his savings with the assurance of a bank, for a certain period, with a specific return. For example, the deposits his money in bank A with a monthly return of 1.5% for 12 months. At the end of 12 months, it will be able to withdraw the principal + interest income.
In another example, imagine an entrepreneur needs a loan of 10,000 USD. With this money, he will start a business and pay off his debt in 3 years. He takes a loan from the bank with a maturity of 3 years, with a monthly interest rate of 3%. It will have paid the principal and interest at the end of the fifth year by making monthly payments. The simple interest formula is A = P (1 + rt).
Why Do Interest Rates Change?
There may be different reasons for changing balances in money markets or goods and services markets. Basically, interest rates vary according to the supply and demand rates in the market. Still, in addition to the supply and demand balances in a country’s market, the Central Bank’s intervention in the money market may cause interest rates to change.
Changes in the service and goods market are also affected by the government’s economic policies. For example, lowering tax rates or increasing the salaries of public employees will affect the market. Examples can be considered valid for this case. Changes in the money market, on the other hand, occur as a result of the Central Bank’s intervention in the money market, in addition to the supply and demand balances in the market. When such situations occur, a new equilibrium point is formed in the market, and the interest rate is shaped according to this equilibrium point.
Most Using Types of Interest
- Fixed Interest Rate
- Variable Interest Rate
- Annual Percentage Rate (APR)
- Prime Interest Rate
- Discounted Interest Rate
- Simple Interest Rate
- Compound Interest Rate
Fixed Interest Rate vs. Variable Interest Rate
Banks charge fixed rates or variable rates when lending. Fixed rates remain the same for the duration of the loan, for example, 24 months with equal maturity. In this type of loan, most of the money paid in the first months is interest. Most traditional mortgages are fixed-rate loans.
Variable odds change with the prime rate. The higher the rate, the higher your loan repayment will be. With this type of loan, you do not pay the same amount over the loan period. For example, a loan program can be prepared in which you will pay 40% of the principal and interest for the first 12 months and 60% for the next 12 months. Loan payments may change during the year.
APR vs. APY
APR is short for “annual percentage rate.” It shows the annual cost of your borrowing. Fixed APR is used for credit usage, and variable APR is used for credit cards. The APR calculates the interest expense on your borrowing. APY stands for “annual percentage yield” It shows your annual interest earnings assuming you haven’t added or subtracted from your money all year. APY gives you the most precise information about how much your money will earn annually. APY calculates the interest yield on your income.
While APY includes the interest rate and compound interest, APR includes the interest rate, transaction fees, loan costs.
How Are Interest Rates Determined?
The determination of interest rates may vary according to a country’s economic policy and management style. In countries that have adopted a free market economy and where the financial management and the central bank are autonomous, the central bank or central bank determines the interest rates. The central bank determines the interest rate in a country at the periodic meetings of the monetary policy committee. The Central Bank regularly announces these decisions.
How Does The Central Bank Set Interest Rates?
The Central Bank determines the interest rates in order to affect the markets.
As the last source of liquidity in the economy, the Central Bank lends money to banks in the markets or can borrow money from banks.
Central banks determine interest rates with the expectation of setting a target interest rate in accordance with economic policies and maintaining economic stability. Central banks do so by intervening in markets through open market operations, buying and selling treasury securities to affect short-term interest rates.
In the US, interest rates are set by the Federal Open Market Committee (FOMC). The FOMC determines the short-term direction of monetary policy and interest rates. The FOMC meets eight times in the same year at 1.5-month intervals to determine interest rates. The Fed President chairs the Federal Open Market Operations Committee. It is one of the most important meetings for investors as the Fed makes its interest rate decisions at the FOMC meetings.
Central banks carry out a monetary policy using various tools. The main functions of monetary policies of central banks are as follows:
- To regulate the amount of money circulating in an economy.
- To determine the interest rates applied to the loans.
- Influencing the inflation rate.
How Are Banks Interest Rates Determined?
The interest rate that banks pronounce is usually the nominal interest rate. The nominal interest rate is calculated by adding the real interest rate to the inflation rate. If the deposit interest rate is 5% and inflation is 3%, the real interest rate is actually 2%. The most important factor forming the real interest rate is the risk premium.
Fed Rate (Fed’s Fund Rate)
The interest rate set by the US Federal Reserve affects the entire global economy. Many countries take into account or are indirectly affected by the interest rates announced by the FED. At the end of each trading day, banks borrow from banks with excess cash if their deposit-to-loan ratio is negative. Lenders charge interest within a band determined by the Fed. (For example, between 1.75% and 2.00) This interest rate affects other interest rates in the United States, so it also affects where investment funds worldwide are headed.
ECB Rate (ECB refinancing rate)
The interest rate that the European Central Bank (ECB) uses to fund banks in the Eurozone is referred to as the ECB rate. (ECB refinancing rate) This interest rate affects the investment decisions of European investors, fund management, loan, and interest rates of European banks.
Certain Types Of Interest Rates
Credit Card Interest Rates: The interest rates of credit cards can vary from bank to bank and customer to customer. Upper limits for credit card interest rates can be set by the board of banks or the government. Credit cards have more than one interest rate depending on the product offered to the customer. For example, balance transfers, cash advances, and purchases all have different interest rates.
Mortgage Interest Rates: A mortgage is a housing loan. Interest rates are lower than other housing loans. However, the maturity periods offered to customers in this real estate finance system are much longer.
Vehicle Loan Interest Rates: A car loan is a type of loan that divides the vehicle price into terms with a lower interest rate than a consumer loan. With this type of loan, it is possible to have the desired vehicle with convenient payment options. Usually, the car purchased on credit stays in the bank’s mortgage until the loan debt is paid off.
What Happens if Interest Rates Increase?
A rate hike stops inflation from rising. As the interest rate increases, the demand in the market decreases, and the propensity to spend decreases. Because when the central bank demands money from the banks, the banks increase the interest rates to raise more money from the market. On the other hand, banks open periodic packages with high interest rates to increase their deposits and increase the interest rates to make customers deposit more money.
As interest rates increase, savings tend to decrease. Individuals and companies prefer to deposit their current savings in banks for high-interest income. Therefore, the demand for goods and services in the market decreases, and the propensity to spend begins to decrease.
Low interest rates increase sales of goods and commodities, especially those sold on credit. Falling interest rates cause consumers to shift their deposits in their bank accounts to investments, making larger investments with additional loans to their existing savings. In such periods, the demand for real estate increases. Savings rates fall. When savers see their bank deposits earn less, they look for more profitable investment methods and are more willing to spend money.
Economics is a branch of science that contains many contradictions. As interest rates decrease and investments increase, savings also decrease, and the current account deficit rises. As the interest rates increase and the savings increase, investments fall, and growth declines. There is always an alternative cost in economics. So when we take a path to fix something, we break something else.
In the figure below (Figure A), “r” shows interest on the vertical axis and “QS” shows savings on the horizontal axis. The line S represents the supply of savings. Savings are interest-sensitive; that is, as the interest rate increases, the amount of savings increases (or vice versa, as the interest decreases, the amount of savings decreases). If the interest rates decrease from “r1” to “r2”, the amount of savings decreases and falls from “q2” to “q1”.
The figure above (Figure B), (r) shows the interest on the vertical axis, and (QI) shows the investment amount on the horizontal axis. The DI line shows the investment demand. Since investments are interest-sensitive, the higher the interest rate, the lower the investment amount. On the contrary, as the interest rate decreases, investments increase. In this case, the DI line will be descending from left to right.
How Are Deposit Interest Rates Determined?
Interest is the cost of money. Banks extend the deposits they collect from consumers as loans to other consumers. Therefore, they calculate both loan interest and deposit interest by establishing a mutual balance. Banks interest rate; It determines the real risk-free interest rate, expected inflation rate, maturity risk premium, default risk premium, and liquidity risk premium.
How Is Interest Calculated?
If we look at it from the market’s point of view, we can define interest as the price that the saver receives in return for making the savings available to the needy for a certain period of time. In terms of economics, interest has two different definitions:
According to the first tariff, interest is the amount of return obtained after the sale of a loan agreement. According to another tariff, interest is the rate of return on the capital used for production purposes.
a) What is Simple Interest?: It is the interest income earned at the end of that period on the deposit deposited for a certain period.
How to calculate simple interest rate:
Interest amount = principal x interest rate x maturity
b) What is Nominal Interest?: The interest that banks declare to apply to deposits is nominal interest. For example, the interest that a bank will give on 12-month deposits at a rate of 3.5% is nominal interest.
c) What is Compound Interest?: The interest earned by adding the interest earned at the end of each month to the principal is called compound interest.
How is the compound interest rate calculated?:
Interest amount = principal x (1 + interest rate for the period) Number of Periods – principal
d) What is Real Interest: It is the interest calculated by subtracting the inflation effect from the nominal interest. The inflation rate that must be calculated is not the inflation rate at the time the money is deposited but the expected inflation rate at the end of the period. This is called “anticipated inflation.”
The real interest is usually calculated by deducting the effect of inflation from nominal interest. However, the net nominal interest rate should be calculated by subtracting inflation.
How is the real interest rate calculated?:
Real interest = (1 + Net Nominal Interest) / (1 + Expected Inflation) -1
Types of Interest in the Markets
a) Deposit interest
The name of the interest is to be obtained in return when money is deposited into this account by opening a deposit account in banks for a certain period of time, for example, for 12 months. According to their maturities, if we classify them, there are two types of deposits: demand deposits and time deposits. Today, some banks reflect low-interest income on their demand deposit accounts under the name of daily interest.
b) Credit interest
Banks offer different loan options to their individual and corporate customers. The maturity difference demanded by the bank in return for these loans is called the loan interest. Banks offer loan packages with different names to different customer groups. for example corporate/commercial loans, SME loans, and individual loans (consumer loans, credit cards, mortgage, etc.)
c) GDS Interests
The Treasury borrows internally and externally to close the public sector deficits and pay the principal and interest debts from previous years. It makes domestic borrowing with Government Bonds (papers with a maturity of 1 year or longer) or Treasury Bills (papers with a maturity of less than one year). These debt papers are generally called Government Domestic Debt Securities (GDDS).
d) Indicator interest
The interest in the secondary market of Government Bonds, which are offered to the market with a maturity of 2 years, paid every 3 or 6 months, and traded mostly as trading, is called Benchmark Interest.
e) Private Sector Bond Interests
Private-sector bonds are debt securities with maturities of 12 months or longer for financing by banks or joint-stock companies. The interest rates of private-sector bonds also differ according to the issuing company’s financial condition and market value.