What Everybody Should Know About Interest Rates
Economics Corner: What Everybody Should Know About Interest Rates
When money is borrowed, the amount of money borrowed is called principle. The additional amount that has to be paid back for the privilege of borrowing is called interest. The interest rate is the interest amount stated as a percentage of the principle amount, per year. This percentage can be used for comparison purposes when different loans have different payment terms.
The first and most obvious thing to know about interest is that with every payment of interest, somebody pays while somebody else gets paid. Interest is a cost to somebody and a source of revenue to somebody else.
Whether you are better off with high interest rates or with low interest rates depends on whether you are on the receiving end or the paying end. For more information regarding which policies to support regarding interest rates, see the section below entitled “How Does the Fed Control Interest Rates?”
Those who pay interest are called debtors, and those who receive interest are called creditors.
- If you borrow money from a bank, you become a debtor and the bank becomes a creditor. But if you put money in an interest-bearing bank account, you are the creditor and the bank is the debtor.
- Bonds are also borrowed money. When a corporation issues bonds, the corporation is the debtor and whoever invests in the bonds become creditors. The same thing holds true with the government. When the government issues bonds, the government is a debtor.
- Each of us could simultaneously be a debtor and a creditor. If we have an outstanding balance which involves the payment of interest, we are debtors. If we put money in a savings account, a certificate of deposit, or any other investment for which we receive interest payments, then we are creditors. Consumers often do both at the same time.
- Investments in bonds involve interest, but investments in stocks do not. If we invest in the stock market, we are shareholders. Being a shareholder makes us neither debtors nor creditors. But if we invest in bond markets, we are actually loaning money to issuers of bonds. We are creditors, and bond issuers are debtors. This is true whether the issuers are corporations or governments.
- Individual investors tend to put more of their investment holdings into the safer bond markets as they get older.
- Businesses tend to be debtors. Interest is a cost of doing business.
- Senior citizens tend to be creditors. Interest might be a prime source of retirement income.
- Taxpayers are debtors in the sense that interest on government bonds will be paid out of the government’s budget. The government’s debt is the sum of outstanding government bonds.
- Consumers might be concerned that high interest costs on businesses will be reflected in the prices that we all pay.
- In general, debtors like low interest rates, and creditors like high interest rates. If we are both debtors and creditors, it isn’t always clear whether we should favor low interest rates or high interest rates. However, the magnitude of interest rates affects the overall economy in ways beyond any individual’s status as a creditor or a debtor.
- Debtors are borrowers, and tend to think of themselves as such. Creditors tend to view themselves as investors – they become creditors for the purpose of making more money through the investment of their money.
Important Aspects of Interest Theory
An interest rate is sometimes referred to as the time value of money. Since the creditor and the debtor both freely enter into an agreement, both theoretically gain something from the transaction. The amount borrowed has to be repaid eventually. But the interest amount is a one-way transaction, from debtor to creditor. The creditor gains wealth at the expense of the debtor, but in theory this isn’t really a redistribution of wealth. The debtor gains an equal amount by having use of the funds for the period of time that the principle amount is outstanding, as evidenced by the fact that the debtor has voluntarily entered into such an agreement. According to theory, interest is a win-win situation. But there are exceptions to the theory.
One important exception could be the difference between reality and the theoretical assumption that both sides enter into a loan agreement freely and on equal terms. Perhaps both sides are not equally “free”. While it is worthwhile to discuss the validity of such a difference, doing so here would distract from the main points I am trying to make regarding the theory that the interest rate is the time value of money.
If the time value of money were the only factor in interest rates, then all interest rates would be identical. Interest rates actually include the following factors:
- The time value of money
- Risk premium
- Liquidity and marketability
- Anticipated inflation
Although these numbers cannot be quantified without assumptions being made, any fair-market interest rate is the sum of these factors.
Creditors will charge a higher interest rate on riskier investments, but will require a lower interest rate on investments which are liquid and/or easy to sell.
The Effects of Inflation on Interest Rates
You may accept the theory that interest payments themselves do not represent the redistribution of wealth, as explained above. But even the theory acknowledges that inflation during the time that a debt is outstanding will cause a redistribution of wealth. Money is loaned today, and repaid at a later time. In the interim, inflation has caused the value of the currency to erode. The money paid back is worth less than the money that is borrowed.
This may sound as if debtors gain in this exchange, and wealth is therefore redistributed from creditors to debtors simply because of inflation. Somebody might have told you that this occurs. But it isn’t necessarily true. Both debtors and creditors are aware of the existence of inflation, and would not be able to reach an agreement unless inflation is built into the interest rate. It’s all part of how market forces work. But we make loan agreements which cover the future, and we can only estimate what the inflation rate will be for that future time frame. Any redistribution of wealth which occurs due to the existence of inflation only occurs to the extent that the anticipated rate of inflation built into market interest rates ends up being different from the actual rate of inflation. This redistribution can occur in either direction, depending on whether inflation was overestimated or underestimated. Such a redistribution isn’t always from creditors to debtors.
Consumer Credit and Credit Cards
Stores won’t tell you this, but store credit is a marketing tactic. If you have a line of credit with a store, you are more likely to spend more money in that store than if you didn’t have a line of credit. This is the reason stores extend credit. The store's management expects the credit lines to generate sales for that store. The stores also expect you to pay interest and perhaps other fees associated with outstanding credit. The store expects you to pay them twice: Once when you buy something on credit, and once again when you pay interest on the outstanding balance. This includes store credit cards.
Don’t judge credit cards on their stated interest rates. It is often difficult for many of us to follow this advice. We are accustomed to thinking in terms of interest rates, and the interest rate on a credit card is often shown to us in big bold numbers. Consumers should think of interest on consumer debt in dollar terms, as a fee for a service. Think in terms of how it affects you in dollars and cents terms, not in interest rate percentage terms. The stated interest rate on a credit card doesn’t tell you the whole story about how much a credit transaction will cost you. There are many factors involved, all of which are hidden in the fine print, and many of them requiring some rather advanced knowledge of finance terminology. Unfortunately, there are no shortcuts to figuring this out. We can either learn to become proficient in the language of the fine print, or we can consult with somebody who is.
How Does the Fed Control Interest Rates?
Most interest rates that we see are market-driven. High demand for loans will drive interest rates up; high supply of loans will drive interest rates down. The Fed uses various tools in order to influence the supply side of the equation. The details are a little complicated for the purpose of this essay, but here is a link to a brief textbook-style discussion of the tools that the Fed uses.
Knowing the reasons why the Fed would want to change interest rates is more important than knowing the specific steps in the process.
Low interest rates put market forces into play which help to increase employment. They are a useful tool during recessions and other periods of high unemployment. Once employment reaches an acceptable level, low interest rates can help the working class receive higher wages. With full employment and higher wages, consumer prices are likely to increase. In terms of the Fed’s monetary policy, there is a trade-off between jobs and wages on the one hand and inflation on the other hand.
Interest rates have been at historical lows for several years now. Inflation has also been at historically low levels, and this is by design. But the Fed is now concerned that further strengthening of the job market will increase inflation, and it wants to increase interest rates to forestall future inflation. But keep this in mind: the tools that the Fed wants to use in order to increase interest rates actually work through slowing job creation and middle-class wage gains. The Fed freely admits to a strategy which will weaken the job market – which is why signs of fragility in the economic recovery have delayed implementation of these plans.
The Fed’s argument for weakening the job market? While the Fed uses tight monetary policy to control inflation, Congress can use activist fiscal policies to strengthen the job market. In other words, Congress can work on the demand side through policies to stimulate the economy. Economically, this is true. The Fed can use tight policy to deal with inflation while the government simultaneously uses loose policy to deal with employment and wages. But doing so requires politicians and voters to support economic stimulus plans, a higher minimum wage, etc.
Perhaps talk about the economy sounds like a bunch of gibberish to you. But if you had a basic understanding of the terminology being used – not the dictionary definitions, but what the words in their context should mean to a layman – free of misleading political implications, then such talk would mean more to you than just gibberish. The good news is that you don’t have to be an economist or even a student of economics in order to understand the terminology.
“Economics Corner: What Everybody Should Know About…” series is designed as a layman-friendly explanation of important economics terms and concepts. Created by Jerry Wyant.