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.
Another key factor in determining interest rates is the lending agency's confidence that the money—and the interest on that money—will be paid in full and in a timely fashion. Default risk encompasses a wide range of circumstances, from borrowers who completely fail to fulfill their obligations to those that are merely late with a scheduled payment. If lenders are uncertain about the borrower's ability to adhere to the specifications of the loan arrangement, they will often demand a higher rate of return or risk premium. Borrowers with an established credit history, on the other hand, qualify for what is known as the prime interest rate, which is a low interest rate.
TERM STRUCTURE OF INTEREST RATES
The actual interest on a loan is not fully known until the duration of the borrowing arrangement has been specified. Interest rates on loans are typically figured on an annual basis, though other periods are sometimes specified. This does not mean that the loan is supposed to be paid back in a year; indeed, many loans—especially in the realm of small business—do not mature for five or ten years, or even longer. Rather, it refers to the frequency with which the interest and "principal owed"—the original amount borrowed—are recalculated according to the terms of the loan.
Interest is usually charged in such a way that both the principal lent and the accrued interest is used to calculate future interest owed. This is called compounding. For small business owners and other borrowers, this means that the unpaid interest due on the principal is added to that base figure in determining interest for future payments. Most loans are arranged so that interest is compounded on an annual basis, but in some instances, shorter periods are used. These latter arrangements are more beneficial to the loaner than to the borrower, for they require the borrower to pay more money in the long run.
While annual compound interest is the accepted measure of interest rates, other equations are sometimes used. The yield or interest rate on bonds, for instance, is normally computed on a semiannual basis, and then converted to an annual rate by multiplying by two. This is called simple interest. Another form of interest arrangement is one in which the interest is "discounted in advance." In such instances, the interest is deducted from the principal, and the borrower receives the net amount. The borrower thus ends up paying off the interest on the loan at the very beginning of the transaction. A third interest payment method is known as a floating- or variable-rate agreement. Under this common type of business loan, the interest rate is not fixed. Instead, it moves with the bank's prime rate in accordance with the terms of the loan agreement. A small business owner might, for instance, agree to a loan in which the interest on the loan would be the prime rate plus 3 percent. Since the prime rate is subject to change over the life of the loan, interest would be calculated and adjusted on a daily basis.
THE INTEREST RATE AND SMALL BUSINESSES
Entrepreneurs and small business owners often turn to loans in order to establish or expand their business ventures. Business enterprises that choose this method of securing funding, which is commonly called debt financing, need to be aware of all components of those loan agreements, including the interest.
Business consultants point out that interest paid on debt financing is tax deductible. This can save entrepreneurs and small business owners thousands of dollars at tax time, and analysts urge business owners to factor those savings in when weighing their company's capacity to accrue debt. But other interest rate elements can cut into those tax savings if borrowers are not careful. Because interest paid on a loan is tax deductible, while other loan charges and fees are not, it may be in the best interest of a small business owner to accept a loan with a slightly higher interest rate if it offers fewer handling charges than a similar loan with a slightly lower interest rate but higher handling fees. The full impact of loan charges and interest rates over time should be made before deciding upon a lender.
Commercial banks remain the primary source of loans for small business firms in America, especially for short-term loans. Small business enterprises who are able to secure loans from these lenders must also be prepared to negotiate several important aspects of the loan agreement which directly impact interest rate payments. Both the interest rate itself and the schedule under which the loan will be repaid are, of course, integral factors in determining the ultimate cost of the loan to the borrower, but a third important subject of negotiation between the borrowing firm and the bank concerns the manner in which the interest on a loan is actually paid. There are three primary methods by which the borrowing company can pay back interest on a loan to a bank: a simple- or ordinary-interest plan, a discounted-interest plan, or a floating interest rate plan.
Securing long-term financing is more problematic for many entrepreneurs and small business owners, and this is reflected in the interest rate arrangements that they must accept in order to secure such financing. Small businesses are often viewed by creditors as having an uncertain future, and making an extended-term loan to such a business means being locked into a high-risk agreement for a prolonged period. To make this type of loan, a lender will want to feel comfortable with the business, the quality of its management, and will want to be compensated for what it sees as higher-than-usual risk exposure. This compensation usually includes the imposition of interest rates that are considerably higher than those charged for short-term financing. As with short-term financing arrangements, interest on long-term agreements can range from floating interest plans to those tied to a fixed rate. The actual cost of the interest rate method that is ultimately chosen appears in interest rate disclosures (which are required by law) as a figure known as the annual percentage rate (APR).
Cooper, James C. "U.S.: From Here On Out, The Fed Is Winging It; More uncertainty over future rate decisions will mean bumpier markets." Business Week. 10 April 2006.
Federal Reserve Board of the United States. Discount Rate. Available from http://www.federalreserve.gov/monetarypolicy/discountrate.htm 16 March 2006.
Walter, Robert. Financing Your Small Business. Barron's Educational Series, March 2004.