The term 'Interest Rate' is included in the Corporate Finance edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Choose your edition here...
Interest rates are the levels at which interest is charged a borrower for using money that they obtain in the form of a loan from a bank or other lender. These are also the rates that individuals and businesses are paid for depositing their funds with a bank. Interest rates are central to the running of capitalist economies. They are commonly written out as percentage rates for a given time frame, most commonly per year.
As an example, a small business might require capital to purchase new assets for the company. To acquire these, they borrow money form a bank. In exchange for making them this loan, the bank is paid interest at a pre set and agreed upon rate of interest for lending it to the company and putting off their own use of the monies. They receive this interest in monthly payments along with repayments of the principal.
Interest rates are also used by government agencies in pursuing monetary policies. Central banks set them to influence their nation’s economic performance. They impact many elements of an economy such as unemployment, inflation, and investment levels.
There are several different interest rates to consider. The most commonly expressed one is the nominal interest rate. This nominal interest rate proves to be the amount of interest that is payable in money terms. If a family deposits $1,000 in a bank for a year, and is paid $50 in interest, then their balance by the conclusion of the year will be $1,050. This would translate to a nominal interest rate amounting to five percent per year.
The real interest rate is another type of rate used to determine how much purchasing power is received. It is the interest rate after the level of inflation is subtracted. Determining the real interest rate is a matter of calculating the nominal rate and removing the amount of inflation from it. In the example above, supposed the economy’s inflation level is measured at five percent for the year. This would mean that the $1,050 in the account at year end only buys what it did as $1,000 at the beginning of the year. This translates to a real interest rate of zero.
Interest rates change for many reasons. They are altered for political gains of parties in power. By reducing the interest rate, an economy gains a short term boost. The help to the economy will often influence the outcome of elections. Unfortunately, the short term advantage gained is often offset later by inflation. This reason for changing interest rates is eliminated with independent central banks.
Another main reason that interest rates change is because of expectations of inflation. Since the majority of economies demonstrate inflation, fixed amounts of money will purchase fewer goods a year from now than they will today. Lenders expect to be compensated for this. Central banks raise interest rates to fight this inflation as necessary.