An interest rate refers to the price which a debtor pays for using money of the lender, which in most cases is the bank. Thus a company borrows a certain amount of money in order to start a business. This money is returned to the lender over a fixed period of time along with a specific interest, determined as a percentage rate.
An interest rate is an important tool of an economy’s monetary policy, and is used to govern variables such as inflation, investment as well as unemployment.
Throughout the period of history, interest rates have been set by central banks or national governments.
Different causes of interest rates
• Deferred consumption: When the lender loans money, there is delay in spending on consumption goods. According to the theory of time preference, people usually prefer use of goods immediately rather than using later. Thus a positive rate of interest will always be there in a free market.
• Inflationary expectations: Economies all over usually exhibit inflation signifying a certain amount of money will buy fewer goods later on in comparison to the present state. The borrower thus requires replenishing the lender on account of this factor.
• Alternative investments: The lender needs to make a choice between utilizing his money on a variety of investments. Thus when he selects one, he gives up the returns from other investments. Different forms of investments do call for funds.
• Investment risks: A risk always remains relating to the borrower going bankrupt, absconding or defaulting on the payment of the loan. Thus the lender usually charges interest which is also a risk premium for ensuring that all his investments are safe.
• Liquidity preference: People usually prefer keeping their resources in a liquid form so that they may be exchanged quickly, contrary to a form that takes lot of time and money for realization.
• Taxes: Taxes may be imposed on some portion of the gains resulting from interest. Thus a lender may seek higher rate of interest in order to compensate for the loss.
Real interest rate and nominal interest rates
A nominal interest rate refers to an amount of interest which is payable in money form. Suppose an individual deposits $100 in a bank for a period of 1 year, and receives an interest of $10. His balance at the year end will be $110. In such a case, the nominal interest rate will be 10% per annum.
The real interest rate is the measurement of the purchasing power associated with interest receipts. This is done through adjustment of the nominal rate on account of inflation. Thus looking at the example above, if a 10% inflation has taken place over the year, then the $110 at the year end has the purchasing power similar to $100 about a year back. Thus the real interest rate in such a situation is zero.
Long term loans in the market usually come with higher interest rates, as these are risky in terms of borrowers defaulting in the payment.