what is the purpose of an interest rate?
In: Economics
It’s the cost to borrow money.
If you want to borrow $500k from me to buy a house and want to pay it back over time, I’m going to want an incentive to give you all that money. So you offer to pay back the original $500 principal plus interest. The rate is how much you pay, usually expressed as a percentage of loan amount.
In the U.S., the Fed sets the rate for banks to borrow from the Fed for overnight reserve requirements, and then most other loans are benchmarked to that, eg. Mortgages might be Fed rate + 2%, car loans +3.5%.
Interest rates are the price of borrowing.
Money is worth more today than in the future. Like, think about it: would you rather have $100 today or $100 one year from now?
If I borrow $100 from you to pay it back one year later at no interest, this is strictly a loss for you. This is why, when lending, people demand interest payments.
Well, what interest rates get chosen? It depends on a lot of factors, like the risk the borrower won’t repay, the value of a dollar to the lender in the here and now, and the amount of dollars the lender has available.
The last is what can be acted upon by policy. Central banks can, in effect, make money more available by loaning it out more cheaply – pushing borrowing costs down across the system. They can, of course, also do the opposite.
An interest rate is a combination of the time value of money and the risk associated with lending.
Money in your pocket is worth more than money in a year, because you have an extra year to do stuff with it. You can put a price on that extra value, and that’s essentially the risk-free interest rate. That’s the rate you’ll get from the US Treasury.
Now, if I tell you I’m going to borrow your money and give it back to you in a year. Assuming everything goes to plan, it’s reasonable for both of us to agree on the risk-free rate. But things don’t always go to plan. If I’m borrowing money, it’s because I don’t have enough money. So maybe a year from now I still won’t have enough money, which means you might not get your money back. So you have to charge a little extra interest to account for that risk. You can maybe charge less extra if I give you some other assurances, like if I don’t pay you can take my house or go after a second person for the payments, or if you know I’m trustworthy.
And then you have to charge a little on top of that if you’re a bank that intends to make a profit, because you can’t run a business by breaking even on every loan. So that’s what goes into the bank’s interest rates.
All those long answers…
Tldr: pay back fast or owe more money.
If you have no incentive to pay back quickly, you won’t and I won’t get my money back. With interest I get either my money back quickly or it hurts you more to pay me later.
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Interest is essentially a charge to the borrower for the use of an asset. Assets borrowed can include cash, consumer goods, vehicles, and property. Because of this, an interest rate can be thought of as the “cost of money”—higher interest rates make borrowing the same amount of money more expensive.
Incentive for someone to lend money to someone else. If there was no interest rate I would gain nothing by lending you money. I’d rather invest it in something where I could gain something.
Interest is the incentive to loan people money.
Why would a bank give you the money to buy a house or car if they were not going to make money off of the deal? So they charge you an interest rate, and the longer it takes you to pay them back, the more money they make.
A loan is a product. If you buy a book from a bookshop it costs, say, £10. If you want to book, you pay its price. You could wait until you stumble across it in the charity shop or your friends buys and lends it to you, but if you want the book *now* you buy it for £10.
A loan is the same way: you want £100 *now*, the cost is, say, 10%. A lender will give you £100, and the fee is £10, assuming you pay it back within the given timeframe.
With a typical product like a book, you pay the fee and take the product. With a loan, you take the product and pay the feel at (or *by*) a later date.
A burger today is $12. A burger in 2030 will be $15. If I give you $12 today, do I want to only receive $12 in the future? No.
Interest rates account for 2 things. First, I’m giving you $12, I want to get something out of it. I also want my $12 to cover inflation (see burger above) over that time.
Depending on the use, there may be other items included. People with low credit scores are charged higher interest rates. There’s a risk they won’t repay entirely, and they pay more for a loan company to accept that risk.
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