In economic theory, interest is what is paid to induce a person with MONEY to save it and invest it in long-term ASSETS rather than spend it or a payment by borrowers for the use of funds. The rate of interest is a product of the interaction between the DEMAND for CAPITAL and the SUPPLY of savings. A higher demand for capital relative to the supply for savings produces higher interest rates, and vice versa. Economic theory also makes a distinction between real and nominal interest rates. A nominal rate is the rate stated in the loan agreement. Real rates are nominal rates minus the rate at which money is losing its value. Thus, a loan agreement may have a rate of 10 percent, but if money is losing its purchasing power at the rate of 1 percent per year, the real rate is only 9 percent. In a loan of $10,000, the borrower will pay the lender $1,000 at a nominal rate of 10 percent, but since the loan is being paid back using dollars that are 1-percent less valuable, the real cost of the loan to the borrower is only 9 percent. Therefore the interest rate of 10 percent can be considered to be made of two parts: the basic rate and a 1-percent adjustment for inflationary pressure. Another important factor in the level of interest rates is RISK. If a particular loan has a higher risk, creditors will require a higher interest rate to induce them to make the loan. To continue the example started in the last paragraph, suppose that the risk-free interest rate is 6 percent. The closest thing to a risk-free rate is the loan of money to the federal government via the purchase of Treasury bills. The 10 percent nominal rate would then be a product of three things: (1) the risk-free rate of 6 percent, (2) a risk premium of 3 percent, and (3) an adjustment for inflationary pressure of 1 percent. Interest rates are also viewed in terms of the loan�s DURATION. Borrowing for up to a week is often referred to as the �overnight� rate. Short-term rates apply to LOANS intended to last up to a year, and long-term rates are for loans lasting over a year. In general, with longer-term loans, there is upward pressure on each of the three elements comprising the interest rate. The risk-free rate is higher, while the longer-term loan has more potential time for something to go wrong. Thus the risk premium is higher and inflationary pressure is more observable over a long period of time. Usually long-term debts have a higher interest rate, but there have been notable exceptions. Rates are usually stated in terms of a percentage payable and as an annual percentage rate. This is true even if the borrowing is for shorter than a year. A 10-percent interest rate infers 10 percent a year. For example, if a loan was for $10,000 for six months, the interest cost would be $500 ($10,000 x 6/12). The federal-funds rate is the rate that banks charge each other when they are making short-term loans to each other. The prime rate is the rate that banks charge their best customers for short-term loans. In the 1970s, lenders were using hidden fees and weird calculations to calculate interest as a way of stating a low interest rate in order to induce someone to borrow from them; however, they then charged a higher interest rate. In response to this, the U.S. government passed a series of CONSUMER PROTECTION laws, including the Fair Credit Billing Act (1975) and the CONSUMER CREDIT PROTECTION ACT (1969). These laws allow lenders to continue their practices, but they must disclose what is termed the annual percentage rate (APR). In addition to standardizing the way that interest is calculated, the APR also considers all the hidden fees in the loan. Consequently, a lender may calculate interest and impose fees as it likes, but it must disclose the APR to its borrowers before they agree to the loan. The law specifies how the disclosure should be made; the simplest way is to ask the lender the APR on the loan and to compare this rate with the APRs quoted by other lenders. Another issue relative to consumer interest rates is their duration. Some low rates are merely introductory and will adjust after a few months to more typical rates. As a result, a loan that was initially appealing may adjust to an unacceptable rate after the introductory period. The intent of most of these types of interest rates is to deceive unwary customers. Introductory rates should not be confused with indexed or adjustable rates�that is, loans with flexible interest rates. In this case the interest rate is indexed to some rate not under the control of either the lender or the borrower, i.e., the prime rate. If an interest rate is stated as �two percentage points above prime,� and the prime rate is 6 percent, then the loan rate is 8 percent. This allows the lender to reduce some of its risk in lending the money. For new loans, the interest rate for an adjustable-rate loan will be lower than the rate for a fixed-rate loan. This is because the lender in an adjustable-rate loan has shifted some of the risk of changing rates to the borrower. Usually the rate is subject to an annual �cap,� or maximum that can be adjusted in one year, and a lifetime cap, over the life of the loan.
See also YIELD CURVE.
Mack Tennyson