Simple Interest Calculator

Interest Rates

An interest rate is the cost the borrower has to pay for borrowing money or on the lender’s side; it is the compensation the lender gets for offering the service of lending money. Without interest rates, banks and other financial institutions would not take the risk of lending their money and individuals would not want to save their cash simply because both parties require a deferment for the opportunity of giving up their spending at the present time. However, prevailing interest rates are constantly changing; this is why different types of loans offer different interest rates. If you are a borrower, a lender, or both, it is important for you to understand the reasons for the differences as well as for the changes.

Borrowers and Lenders

The lender always takes the risk of not being paid for the loan he granted. Therefore, the interest also provides a certain compensation for bearing that risk. Coupled with the default risk is the inflation risk. When you venture into the lending business now, the prices of basic commodities and services may possibly go up by the time the loan is paid, which means that the original purchasing power of the loan would have been decreased. Thus, the interest protects the lender against possible future rises due to inflation.

The borrower on the other hand pays the interest because of the price of gaining the ability and the opportunity to spend at the present as opposed to having to wait for many years just to save enough money. Banks and other financial institutions also borrow money in order to increase their financial activities, whether investing or lending, and pay interests to their clients for the service provided to them.

How the Interest Rates are Determined

1. The Supply and Demand - The levels of interest rate are an important factor in the credit’s supply and demand. This means that an increase in the demand will raise the interest rates, whereas a decrease in the credit’s demand will decrease the interest rates. On the other hand, an increase in the credit’s supply will decrease the interest rates while a decrease in the credit’s supply will increase the interest rates.

1. Government – The government dictates how the interest rates are affected. The Fed or the U.S. Federal Reserve often announces how the interest rates will be affected by the monetary policy. The federal funds rate affects the interest rates the banks set on the amount of money they lend. The interest rates then trickle down eventually into the rates for other short-term lending. These rates are influenced by the Fed by the utilization of “open market transactions”, which is fundamentally the act of buying and selling U.S. securities issued previously. When more securities are bought by the government, the banks are injected with more funds, more than what they can use for lending; thereby, decreasing the interest rates. When the securities are sold by the government, the funds from the banks are drained for the financial transaction, rendering lesser funds at the disposal of the bank for lending; thereby, forcing a sudden increase in the interest rates.

1. Inflation – The levels of interest rates are also affected by inflation. The higher the inflation rates, the more interest rates will likely rise. This happens because the lenders usually require higher interest rates as the compensation for the reduction in the money’s purchasing power that should be repaid in the future.