Home Equity Loan
Interest Rates
An interest rate is the price a borrower pays for the use of money he
does not own, and the return a lender receives for deferring his consumption, by
lending to the borrower. Interest rates are normally expressed as a percentage
over the period of one year.
Interest rates are also a vital tool of monetary policy and are used to control
variables like investment, inflation, and unemployment.
Causes of interest rates
Deferred consumption. When money is loaned the lender delays spending the money
on consumption goods. Since according to time preference theory people prefer
goods now to goods later, in a free market there will be a positive interest
rate.
Inflationary expectations. Most economies generally exhibit inflation, meaning a
given amount of money buys fewer goods in the future than it will now. The
borrower needs to compensate the lender for this.
Alternative investments. The lender has a choice between using his money in
different investments. If he chooses one, he forgoes the returns from all the
others. Different investments effectively compete for funds.
Risks of investment. There is always a risk that the borrower will go bankrupt,
abscond, or otherwise default on the loan. This means that a lender generally
charges a risk premium to ensure that, across his investments, he is compensated
for those that fail.
Liquidity preference. People prefer to have their resources available in a form
that can immediately be exchanged, rather than a form that takes time or money
to realise.
Real vs nominal interest rates
The nominal interest rate is the amount, in money terms, of interest payable.
For example, suppose a household deposits $100 with a bank for 1 year and they
receive interest of $10. At the end of the year their balance is $110. In this
case, the nominal interest rate is 10% per annum.
The real interest rate, which measures the purchasing power of interest
receipts, is calculated by adjusting the nominal rate charged to take inflation
into account. (See real vs. nominal in economics.)
If inflation in the economy has been 10% in the year, then the $110 in the
account at the end of the year buys the same amount as the $100 did a year ago.
The real interest rate, in this case, is zero.
After the fact, the 'realized' real interest rate, which has actually occurred,
is:
Market interest rates
There is a market for investments which ultimately includes the money market,
bond market, stock market and currency market as well as retail financial
institutions like banks.
Exactly how these markets function is a complex question. However, economists
generally agree that the interest rates yielded by any investment take into
account:
(a)
The risk-free cost of capital
(b)
Inflationary expectations
(c)
The level of risk in the investment
(d)
The costs of the transaction
Risk-free cost of capital
The risk-free cost of capital is the real interest on a risk-free loan. While no
loan is ever entirely risk-free, bills issued by major nations like the United
States are generally regarded as risk-free benchmarks.
This rate incorporates the deferred consumption and alternative investments
elements of interest.
Inflationary expectations
According to the theory of rational expectations, people form an expectation of
what will happen to inflation in the future.
They then ensure that they offer or
ask a nominal interest rate that means they have the appropriate real interest
rate on their investment.
Risk
The level of risk in investments is taken into consideration. This is why very
volatile investments like shares and junk bonds have higher returns than safer
ones like bank deposits.
The extra interest charged on a risky investment is the risk premium. The
required risk premium is dependent on the risk preferences of the lender.
If an investment is 50% likely to go bankrupt, a risk-neutral lender will
require their returns to double. So for an investment normally returning $100
they would require $200 back. A risk-averse lender would require more than $200
back and a risk-loving lender less than $200. Evidence suggests that most
lenders are in fact risk-averse.
Generally speaking a longer-term investment carries a maturity risk premium,
because long-term loans are exposed to more risk of default during their
duration.
Liquidity preference
Most investors prefer their money to be in cash than in less fungible investments. Cash is on hand to be spent immediately if the need arises, but some investments require time or effort to transfer into spendable form. This is known as liquidity preference. A 10-year loan, for instance, is very illiquid compared to a 1-year loan. A 10-year US Treasury bond, however, is liquid because it can easily be sold on the market.
Interest rate notations
What is commonly referred to as the interest rate in the media is generally the
rate offered on overnight deposits by the Central Bank or other authority,
annualized.
The total interest on an investment depends on the timescale the interest is
calculated on, because interest paid may be compounded.
In finance, the effective interest rate is often derived from the yield, a
composite measure which takes into account all payments of interest and capital
from the investment.
In retail finance, the annual percentage rate and effective annual rate concepts
have been introduced to help consumers easily compare different products with
different payment structures.
Interest rates in macroeconomics
Output and unemployment
Interest rates are the main determinant of investment on a macroeconomic scale.
Broadly speaking, if interest rates increase across the board, then investment
decreases, causing a fall in national income.
Interest rates are set by a government institution, usually a central bank, as
the main tool of monetary policy. The institution offers to buy or sell money at
the desired rate and, because of their immense size, they are able to
effectively set i*n.
By altering i*n, the government institution is able to affect the interest rates
faced by everyone who wants to borrow money for economic investment. Investment
can change rapidly to changes in interest rates, affecting national income.
Through Okun's Law changes in output affect unemployment.
Money and inflation
Loans, bonds, and shares have some of the characteristics of money and are
included in the broad money supply.
By setting i*n, the government institution can affect the markets to alter the
total of loans, bonds and shares issued. Generally speaking, a higher real
interest rate reduces the broad money supply.
Through the quantity theory of money, increases in the money supply lead to
inflation. This means that interest rates can affect inflation in the future.