what is the purpose of an interest rate?
In: Economics
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.
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