Interest Rates

Related Terms: Banks and Banking; Credit; Loans

Lenders of money profit from such transactions by arranging for the borrower to pay back an additional amount of money over and above the sum that they borrow. This difference between what is lent and what is returned is known as interest. The interest on a loan is determined through the establishment of an interest rate, which is expressed as a percentage of the amount of the loan.

Borrowing is a staple in many arenas of the U.S. economy. This has resulted in a dizzying array of borrowing arrangements, many of which feature unique wrinkles in the realm of interest rates. Common borrowing and lending arrangements include business and personal loans (from government agencies, banks, and commercial finance companies), credit cards (from corporations), mortgages, various federal and municipal government obligations, and corporate bonds. In addition, interest is used to reward investors and others who place money in savings accounts, individual retirement accounts (IRAs), Certificates of Deposit (CDs), and many other financial vehicles.

TYPES OF INTEREST RATES

The "prime rate" is probably the best-known interest rate. It is the rate at which commercial banks lend money to their best—most creditworthy—customers. However, in order to track interest rates logically, one should start with the Federal Reserve's "discount rate." The discount rate is the interest rate that banks are charged when they borrow money overnight from one of the Federal Reserve Banks. There are twelve Federal Reserve Banks, each of which is a part of the nation's central bank and plays a part in setting the monetary policy of the United States.

Commercial banks pass along the cost of borrowing money when they establish the rates at which they lend money. One factor in establishing those rates is the discount rate established by the Federal Reserve Bank, although other factors play into the calculation. The prime rate is the lowest rate at which commercial banks lend. Although often thought of as a set interest rate, the prime lending rate is not actually a uniform rate. National City Bank may, for example, have one rate while CitiBank has another slightly different rate. As a result, the most widely quoted prime rate figure in the United States is the one published in the Wall Street Journal. What they publish is an average rate that results from polling the nation's thirty largest banks; when twenty-three of those institutions have changed their prime rates, the Wall Street Journal responds by updating the published rate. The reason that the prime rate is so well known is that it is used as a basis off of which most other interest rates are calculated.

Other important interest rates that are used in making capital investment decisions include:

• Commercial Paper Rate—These are short-term discount bonds issued by established corporate borrowers. These bonds mature in six months or less.
• Treasury Bill Rate—A Treasury bill is a short-term (one year or less) risk-free bond issued by the U.S. government. Treasury bills are made available to buyers at a price that is less than its redemption value upon maturity.
• Treasury Bond Rate—Unlike the short-term Treasury bills, Treasury bonds are bonds that do not mature for at least one year, and most of them have a duration of 10 to 30 years. The interest rates on these bonds vary depending on their maturity.
• Corporate Bond Rate—The interest rate on long-term corporate bonds can vary depending on a number of factors, including the time to maturity (20 years is the norm for corporate bonds) and risk classification.

How interest rates are established, why they fluctuate, and why they vary from lender to lender and borrower to borrower are complicated matters. Two terms used in banking whose definitions it will be helpful to know in reading further about interest rates are "real" and "nominal." The "real" interest rate on a loan is the current interest rate minus inflation. It is, in essence, the effective rate for the duration of the loan. The "nominal" interest rate is the rate that appears on the loan agreements, the stated rate that does not account in any way for inflation.

FACTORS THAT INFLUENCE INTEREST RATES

Interest rate levels are determined by the laws of supply and demand and fluctuate as supply and demand change. In an economic environment in which demand for loans is high, lending institutions are able to command more lucrative lending arrangements. Conversely, when banks and other institutions find that the market for loans is a tepid one (or worse), interest rates are typically lowered accordingly to encourage businesses and individuals to take out loans.

Interest rates are a key instrument of American fiscal policy. The Federal Reserve determines the interest rate at which the federal government will bestow loans, and banks and other financial institutions, which establish their own interest rates to parallel those of the "Fed," typically follow suit. This ripple effect can have a dramatic impact on the U.S. economy. In a recessionary climate, for instance, the Federal Reserve might lower interest rates in order to create an environment that encourages spending. Conversely, the Federal Reserve often implements interest rate hikes when its board members become concerned that the economy is "overheating" and prone to inflation.

By raising or lowering its discount interest rate on loans to banks, the Federal Reserve can make it attractive or unattractive for banks to borrow funds. By influencing the commercial bank's cost of money, changes in the discount rate tend to influence the whole structure of interest rates, either tightening or loosening money. When interest rates are high, we have what we call tight money. This means not only that borrowers have to pay higher rates, but that banks are more selective in judging the creditworthiness of businesses applying for loans. Conversely, when interest rates decline, money is called easy, meaning that it is both cheaper and easier to borrow. The monetary tools of the Federal Reserve work most directly on short-term interest rates. Interest rates charged for loans of longer duration are indirectly affected through the market's perception of government policy and its impact on the economy.

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