Friday, June 13, 2008

Understanding Interest Rates

Interest rates are constantly in the news, and we all know they have an important effect on the economy and our personal finances; but, the bewildering array of interest rates can become confusing. This is hopefully a simplified guide to how interest rates affect the economy and individuals.

What are Interest Rates?

Interest rates are often referred to as the Cost of Money. This is because interest rates determine the cost of borrowing money. When interest rates are high, there is a disincentive to borrow, but saving money becomes more attractive.

Real Interest Rates.

  • Real interest rates = Nominal Interest rates - Inflation
It is important to bear in mind that the impact of interest rates depends upon the inflation rate. If interest rates are 10% and inflation is 9%. It means that saving money in a bank will give a real interest rate of only 1%

If interest rates are 5% and inflation is 3% (like at the present) it means real interest rates are actually higher than other example (2%) In a period of deflation, real interest rates can be quite high even if nominal interest rates are quite low.

Base Rates

This is the main interest rate set by the Monetary authority. In the UK base rates are set by the Bank of England. In the US base rates are set by the Federal Reserve. This base rate is the rate at which commercial banks borrow from the Central Bank and therefore influences all the other interest rates in an economy. But, note, the federal Reserve does not control commercial interest rates - it only controls the base rate.

Interest Rates and the Economy

Interest rates are used to influence inflation and economic growth. Basically, higher interest rates will reduce consumer spending and investment. This will slow down economic growth and help reduce inflation. The Monetary authorities thus face a trade off between reducing inflation and slower economic growth.

Commercial Bank Rates.

Recently, it has been noted that banks have been increasing interest rates for borrowing, even though Central banks have been cutting rates. This is because the credit crisis has encouraged banks to increase their commercial rate margin. Because banks are short of credit they want to encourage people to save and reduce availability of credit. This means the margin between bank rates and the main base rate has increased. Basically, the banks are seeking to make saving more attractive. This is also reflected in an increase in the interbank lending rate.

Interbank Lending Rates.

Banks are often temporarily short of cash, so they borrow from other banks. This helps to maintain greater liquidity in the banking system and means banks can have lower liquidity ratios. However, because of the credit crunch the interbank lending rate has increased making it more expensive for banks to borrow from each other.

Interest Rates and Risk

If you take out a mortgage loan, the bank sees the loan as fairly secure because the loan is guaranteed against the value of the house. Therefore, the borrowing rate for mortgages is quite low. However, if you take out an unsecured loan, it means if you fail to repay the bank will lose all their money because they cannot claim against an asset. To compensate for the risk they will set a higher interest rate. This is why people with poor credit tend to face higher rates.

Interest Rates and homeowners.

Homeowners with a variable mortgage will be affected by any change in interest rates. For example, if you have a £100,000 mortgage a 50 basis point change in interest rates will affect your monthly payments by about £50. If homeowners want to avoid interest rate volatility then can get a fixed rate mortgage. Otherwise the cost of your mortgage will vary with changes in the interest rate.

Forecasting Interest Rates

The future trend of interest rates depends mostly on the future direction of the economy. If the economy is forecast to grow and increase inflation, interest rates are likely to increase to keep inflation low. In a recession, inflationary pressures diminish and so rates can usually be cut.

Interest Rates and Oil Prices

If oil prices increase (e.g. 2007-08) it causes both inflation (cost push inflation) and lower growth. Therefore this presents a dilemma. The monetary authorities would like to cut rates to boost growth. But, they would also like to increase interest rates to reduce inflation. This shows that interest rates can not solve a country's problems.

Interest Rates and the Exchange Rate

An increase in interest rates makes a currency more attractive. This causes hot money flows into an economy causing an appreciation. Similarly a cut interest rates will often cause a depreciation in the currency.

Why Do Interest Rates vary from 0% to 2,000%?

The reason is that banks use interest rates to determine the profitability of lending. Credit card companies charge interest rates of 17% basically because they can get away with it. Credit card debt is therefore very profitable for credit card companies. Pay day loans can have annual interest rates of upto 2,000%. It is a very expensive way to borrow money, but there is still the demand for this kind of loan.
If you put money in a current account (checking account in US) then the interest rate may be very low. This is because the bank may not see a current account as very profitable. A savings account with time limits on withdrawals will give a higher interest rate.

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