What you should know about Interest Rates

Interest is a fee charged for the use of funds. It is the “rent” charged for the use of money. Interest is the mechanism that makes the lending and borrowing of money between two parties possible. Without interest, there would be little incentive for a person of organisation to allow someone else to use money that is available.

Banks are in the business of lending funds to clients. Banks profit from the interest charged. Typically banks pay interest to cash investors for money entrusted to them. This money is used to finance more risky ventures at a higher rate.

Most businesses rely to some extent on the availability of interest-bearing credit. Without it, much business would simply grind to a halt.

Mary needs $10,000 to help fund her new restaurant. John has the money available, and is willing to lend the money to Mary with interest accruing at a rate of 10 % per annum. After a year, Mary will owe John $10,000 plus $1,000 interest. Both John and Mary have benefited from this agreement. John has earned money simply by letting Mary make use of it. The loan allowed Mary to start a new restaurant.

The rate of interest that John charged to Mary was governed by a few factors. The first was the central bank’s rate of interest. The central bank is generally a lender of last resort to the commercial banks, and the rate of interest announced from time to time relates to the overnight rate that the central bank will charge to lend money to the commercial banks.

The commercial banks will usually charge interest at a rate that is a few percentage points above the central bank rate. They will also pay investors a rate that is somewhat lower. The commercial banks usually define the prime rate as a rate that the bank will charge to a low risk customer. Often, the bank may charge interest on an overdraft at a rate of prime plus one or two, or three… percentage points. The rate is based on the perceived risk. A high risk customer may be charged at prime plus five or simply declined. A good customer could be offered a rate below prime.

Most interest in today’s financial world is based on the application of the principals of compound interest. In Mary’s agreement with John, she does not have to make a payment until after ten years. She will be charged compound interest at a fixed rate on the balance owing. Mary is free to reduce the debt at any time.

At the end of year one, Mary owes John $11,000. She chooses not to make a payment at this time. The interest at the end of year two is $1,100, giving a balance of $12,100. At the end of year three, the interest is $1,210 and Mary’s debt has crept to $13,310. Mary now makes a payment of $3000, but she still owes $10,310.

Compound interest means that as the interest is calculated it is added to the capital amount. The new amount is the basis for the next calculation.

If you are earning compound interest, you benefit from the interest earned in previous years as long as you have opted to reinvest that interest.

If you have debt on which you are charged compound interest it is important to ensure that you pay at least enough to cover the interest. A failure to do that could result in your debt growing exponentially.

Often the rate of interest levied against a loan will be tied to the prevailing central rate of interest. Central banks change this rate from time to time in an effort to control inflation and to control economic growth.

Interest charged by reputable lenders is generally closely aligned to the central bank rate. When people are desperate they may resort to much more outrageous rates. In some cases your debt doubles every few days and failure to pay can result in the loss of limbs or even the loss of life.

Before you sign any interest related agreement, make sure that you have read and understood the contract. If the contract is very one-sided, negotiate more favourable terms. Even if you are desperate, do not fall for the loan-sharps. It could end up costing you much more than you had bargained for.