Interest Rates

An interest rate is the cost of borrowing money.

The borrower pays interest in order to spend money now, instead of waiting until he's saved the same amount.

Interest Rates


For example, if you borrow $1,000 at an annual interest rate of 10%, at the end of the year you'll owe $1,100.

The interest a lender receives is his compensation for taking a risk.


The higher the risk that the borrower will fail to repay the loan is, the higher the interest rate.


The nice thing is that interest rates work both ways!

Banks, governments and other large financial institutions need cash too and they're willing to pay for it.

If you put money into a savings account at a bank, the bank will pay you interest for the use of your money.

Governments sell bonds and other securities for the same reason.

In this case, you are the lender and the interest rate is your compensation for giving up the ability to spend your money.



For example, interest rates for unsecured credit will always be higher than secured credit.


Secured credit is backed by collateral.





Another factor that makes long-term loans less attractive to lenders - and therefore raises long-term interest rates is the rate of inflation.

In a healthy economy, inflation almost always rises, meaning the same dollar amount today is worth less in ten years from now.


That's why interest rates are actually calculated as two different values:

A. The nominal rate is the interest rate set by the lending institution and

B. The real rate is the nominal rate minus the rate of inflation.

For example, if you have a mortgage with a nominal interest rate of 12%, but the annual rate of inflation is 5%, then the bank is only really collecting 7% on the loan.


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