What is an Interest Rate?
How Does an Interest Rate Work?
The formula to find an interest rate of a loan is:
Interest Rate = (Total Repayment Amount - Amount Borrowed) / (Amount Borrowed)
Let's assume XYZ Company is considering building a new $50 million factory. If a bank agrees to lend XYZ the $50 million dollars but requires XYZ to pay back $55 million at the end of the year, we can calculate that XYZ will pay $5 million ($55 million repaid - $50 million principal) to borrow the money. This translates to:
Interest Rate = ($5 million) / ($50 million) = 10% interest
Interest is often compounded, meaning that the interest earned on a savings account, for example, is considered part of the principal after a predetermined period of time. Interest is then earned on the larger principal balance during the next period and the process begins again. The more frequently interest is compounded, the more interest is earned (or paid) on an investment.
Four things influence interest rates: the risk of default, the length of the loan, inflation rates, and the real rate. Interest rates are generally higher for borrowers who are more likely to default. The U.S. Treasury, which can literally print money, is considered a risk-free borrower and thus pays very low interest rates on its debt (Treasury securities). Additionally, the probability that interest rates will change or borrowers will default increases over time, meaning that loans with longer maturities tend to carry higher interest rates. The short- and long-term effects of inflation also motivate lenders to seek compensation in the form of higher interest rates for the expected erosion of purchasing power on their funds. After the default, maturity, and inflation components are removed from an interest rate, the borrower is left with the "real" interest rate necessary to induce the lender to forego use of the funds.
Why Does an Interest Rate Matter?
Interest rates are one of the economy's single strongest influences. They facilitate the formation of capital and have a profound effect on everything from individual investment decisions to job creation, monetary policy, and corporate profits.
In a free market economy, the laws of supply and demand generally set interest rates. The demand for borrowing is inversely related to interest rates, meaning that high interest rates discourage companies and individuals from borrowing (usually to undertake capital spending projects), and low interest rates encourage borrowing. However, demand for funds also stems from the productivity of the investments undertaken with the borrowed capital. For example, XYZ Company might be willing to pay a higher interest rate as long as the new factory's return on investment (ROI) exceeds the cost of the funds. However, companies have to work harder to generate higher returns in a high-ir605 environment.
Borrowing can only occur when another person or company agrees to forego current consumption and lend the money to the borrower. However, the interest rate must be high enough to convince these lenders to lend. This is why the supply of loanable funds increases when interest rates rise.
Interest rates affect the prices of many investments, especially stocks, because they are key components of present value and future value calculations. In particular, the dividend discount model, which calculates the fair value of a share of stock by discounting the share's future cash-flows using a required rate of return that incorporates risk and current interest rates, is a reason stock prices typically rise when interest rates fall (and vice versa).
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