What is interest rate? Definition and meaning
The definition and meaning of interest rate may refer to the annualized cost of credit, the annual percentage growth of a savings account, or the rates set by a central bank at which the rest of the banks in the country can lend to each other. When you borrow money from a bank, you will have to pay back the principal or capital (the original amount borrowed) plus interest – how much interest depends on the lender’s interest rate and how long the borrower takes to pay back all the money.
Banks can determine their own interest rates on loans and savings, however, as they are all closely linked to how the central bank sets rates, in practice they are approximately the same.
Interest rates are not set purely by the economic laws of supply and demand. Every bank that has money to lend does not set rates independently based on what the market can bear.
If you want to borrow money, go to a reputable bank, it will charge you a much more reasonable rate than a loan shark. All banks charge higher interest rates on their loans than they pay out to savers – that is how they make a profit.
According to Dictionary.Cambridge.org, interest rate is:
“The interest percent that a bank or other financial company charges you when you borrow money, or the interest percent it pays you when you keep money in an account.”
The interest rate on a loan is usually noted on an annual basis, known as the APR (annual percentage rate). APR is made up of interest rate plus any arrangement fees that are automatically included in the loan.
In most cases, a low-risk borrower will pay a lower interest rate than a high-risk one.
Interest rates and central banks, what does it mean?
The interest rates that borrowers pay and savers receive are closely linked to what is set by the central bank. Examples of central banks include the US Federal Reserve System (Fed), the Bank of England, the Bank of Canada, the Reserve Bank of Australia, the European Central Bank and the Bank of Japan.
Usury refers to charging an exorbitant interest rate. In some religions, it is a sin to charge interest on loans, no matter how small. When London-based lender Wonga was charging an APR of 5,853%, the British Financial Conduct Authority made the company pay redress for unfair debt collection practices.
Central banks have several duties, including regulating banks and conducting monetary policy, i.e. controlling the supply of money.
When inflation appears to be increasing, the Fed and other central banks work to reduce the money supply to halt inflation.
When the economy is waning or they believe it is about to slow down, and unemployment is on the rise, central banks expand the money supply to encourage consumers to spend and companies to invest.
The control of the money supply occurs through interest rate manipulation by the central bank – it either raises or reduces interest rates. Manipulating interest rates does not always work as planned. However, for the most part, it has proved to be an effective tool.
After an interest rate rise, business activity and consumer spending are dampened because credit becomes more expensive. The stock market also suffers when interest rates go up, because investors can obtain a better return from newly-issued bonds or bank deposits, so they switch from investing in shares.
Example of interest rate on a loan
When we borrow money, we have to pay back the principal – the original amount – plus the interest. Imagine that Fred Jones borrows $1,000 from a bank:
If his loan attracts an annual interest rate of 10%, he will have to pay back $1,000 plus $100 (10% interest). So, the total amount he will have to pay back after one year is $1,100.
The total amount will be more than $1,100 if Fred borrows the money for longer than one year, and less if he pays it back in less than a year.
Interest rate is a term with which citizens in every country across the world are familiar.
The interest rate is influenced by a number of factors, including:
– what the government’s directives are regarding the central bank’s goals,
– supply and demand in the market,
– whether the borrower is perceived as high-, medium- or low-risk,
– the investment’s term to maturity, and
– the currency of the money lent or borrowed.
Terms related to interest rate
– Base Rate: also called the bank rate. It is the annualized rate offered on overnight deposits by the central bank.
– Annual Percentage Rate (APR): used to help consumers compare goods and services with different payment structures on a common basis. Also known as the Annual Equivalent Rate (AER) or Effective Annual Rate (EAR).
– Coupon Rate: for an interest-bearing security, it is the ratio of the annual coupon amount (coupon paid per year) per unit of par value. The current yield, on the other hand, is the ratio of the annual coupon divided by its market price at the moment.
Ben Bernanke is an American economist who currently works at the Brookings Institutions. He served two terms as Chairman of the Federal Reserve – from 2006 to 2014. He was born in 1953 in Augusta, Georgia to Philip and Edna Bernanke, a pharmacist and elementary school teacher respectively. (Image: Brookings Institution)
Interest rates through history
Over the past two hundred years, interest rates have varied considerably, and have been set by central banks or national governments.
The Fed’s federal funds rate in the US ranged from 0.25% to 19% between 1954 and 2008, while the base rate of the Bank of England varied between 0.5% and 15% between 1989 and 2009.
Germany saw an interest rate nearing 90% in the 1920s, while in the 2000s it declined to about 2%. The Central Bank of Zimbabwe raised interest rates for borrowing to 800% in its failed attempt to tackle spiraling hyperinflation.
The Bank of England has been setting interest rates since 1694, and has one of the world’s most complete economic datasets regarding central bank interest rate manipulation.
David Cameron was Prime Minister of the United Kingdom from May 2010 until July 2016. He resigned after a referendum in which Britons voted by a slim margin for Brexit (Britain Exiting the European Union). He was born in 1966 in Marylebone in London, to Ian Donald Cameron, a stockbroker, and Mary Fleur, a Justice of the Peace. (Image: twitter.com/david_cameron)
Below is a list of some interest rates throughout history (Source: Business Insider):
– 20% in Mesopotamia, c. 3000 BC.
– 20% in Babylon, 1772, BC, according to the Code of Hammurabi, one of the oldest deciphered writings of significant length in the world.
– 40%+ when King Cyrus took Babylon during the Persian conquest, 539 BC.
– 10% Greece, 500 BC.
– 8.33% Rome, 443 BC.
– 8% Athens/Rome during the first two Punic Wars, 300-200 BC.
– 4% Rome, 1 AD.
– 15% Rome, under Diocletian, 300 AD.
– 12.5% Byzantine Empire under Constantine, 325 AD.
– 8% Byzantine Empire, according to Code of Justinian, collections of laws and legal interpretations sponsored by Justinian I, the Byzantine emperor. 528 AD.
– 20% various Italian cities, c. 1150.
– 20% Venice, 1430s.
– 6.25% in Venice when Lenoardo da Vinci painted ‘The Last Supper in Milan’, 1490s.
– 8.13% Holland, at the start of the Eighty Years’ War, 1570s.
– 9.92% England, 1700s.
– 7.64% United States, West Florida annexed, 1810s.
– 1.85% USA, 1940s, during WWII.
– 15.84%, during President Ronald Reagan’s administration in the 1980s.
– 0-0.25% United States, September 2015.
– 0.25-0.5% United States, December 2015.
Video – What is interest rate? – Definition and Meaning
This Money and Society video explains the basics of interest rates, how they work, and how the US Fed can change them through means of the money supply. The speaker also discusses how interest rates over the past twenty years have changed, and how these changes contributed to the 2007/8 financial crisis.