Speaking in the most basic terms, interest is a fee that is charged for the use of borrowed assets. It is the service charge that a lender asks for in payment from a borrower in exchange for the use of money or capital.
Understanding Interest Rates
An interest rate is an amount per dollar or the percent of the money borrowed that is charged. For example, suppose Jill borrowed one dollar from Bob. Bob may ask for seven cents in return for the privilege of using his dollar. In that instance, the interest rate would be 7%. This is because exactly 7% of the money borrowed is equal to the amount Jill owes Bob.
Value and Time
You may ask if Jill must pay the dollar back to Bob, plus the 7% interest rate — that means she eventually ends up paying $1.07, which is more than she is borrowing. In the end, she loses money. That is true, in essence. However, because of inflation, and because of the expectation of investment, the value of a dollar is always greater at an earlier time than it is at a later time.
To understand why that is true, think about all the money a person may earn over a lifetime. According to usgov.info, the average person earns $1.8 million dollars over the course of his or her lifetime. This money comes in the form of paychecks, tax returns and other forms earned slowly over the course of a lifetime. The individual must wait between paychecks and slowly invest in the things that they need to enrich and build up their financial estate.
Now, imagine if you were able to get the entire $1.8 million all at once at an early age. You would be able to buy a home outright, start a business or make other investments that would be quite likely to support you for life. So you can see that $1.8 million now is much more valuable than it would be over a long period of time.
This is why lenders are able to charge interest. The expectation is that Jill will spend Bob’s dollar in such a way that will enable her to earn more than one dollar, and when it comes time to pay Bob back, her expectation is that she will have made a profit on the overhead represented by the loan.
Rates in the Lending Market
With any other product for sale on the open market, interest rates are subject to market forces. The ordinary effects of supply and demand have a great deal to do with the rates of interest that a lender can charge in a given scenario.
The average interest rates for a home loan, or a mortgage, for example, are between 3.55% and 3.75% as of November 2016. These numbers will go up and down depending on forces affecting the real estate market, as well as forces affecting the lending trade.
Risk and Credit
However, when it comes to determining the interest rate a given borrower will be asked by a lender to pay, it isn’t just market forces that will determine the rate of interest. Borrowers will be expected to pay a rate that compensates the lender for taking the risk that the borrower may fail to pay the loan back. This is called a default.
When a borrower defaults on a loan, the lender either loses the money, or they may pursue legal action in order to recover it. In some cases, the borrower can escape making a full repayment. For that reason, lending is risky.
A borrower will have to submit an application in most cases where his or her credit score is examined. Those with a good credit score, showing a reliable payment history can enjoy a lower rate of interest. Borrowers with a bad credit score, or a history of being unreliable when it comes to repaying debts, will probably have to accept higher rates of interest.
If a borrower’s payment history is sufficiently poor, few lenders will accept the risk inherent in lending to that person.
Interest Rates and the Federal Reserve
Finally, the greatest influence on interest rates in the economy is the Federal Reserve. This governmental body is responsible for setting the limits within which lenders can assign the rates of interest that they charge their customers. The way the Fed does this is by controlling how much money is able to circulate in the economy.
Consider for example, that the economy is rapidly contracting. In that case, the Federal Reserve may print more money and release it into the economy. This means there is more money available, but it also means that money goes down in value. Just as in the law of supply and demand, money that is more readily available is less valuable.
At the same time, however, when there is more money in the economy, lenders are more willing to make loans. This causes the average rate of interest on loans to go down.
Naturally, a properly balanced economy can be difficult to maintain. That is why so many financial experts are always working hard to make predictions and why investors are always scrambling to find the best investments to make.
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