Cross a street, or just sit in a coffee shop close to a busy street and you will see them - flapping from lampposts, splattered on walls or passing in front of you on the side of large vehicles. "Buy your first HOME! Lowest Interest Rate Ever", "Get a personal loan. 0.01% above BLR", or even "Zero rate interest. Get your loan now."
The word interest rate seems to be everywhere we look. Most of us sort of have an idea of what they are and that is why whenever we start talking about rates of any kind, we tend to use the word "you know..." to close to our opinions. A few even make do by comparing the rates of different banks or loan types. This one is better than that, or that is the best of all. But how are these rates defined? Will the definition affect how high or low the rates are? Some loans may even appear to have the same interest rate but if you read the contract clause carefully, you may find different conditions attached to either one of them.
Usually what we see appearing on the news are announcements from the Central Bank about whether or not it will be raising rates. This is a big deal to investors and business owners because it will affect their demand for money. Banks usually add a small amount onto the Base Lending Rate, so that they can earn a little for their institution. So when the total rate is 4%, a business have to pay 4 cents for every dollar it borrows for a year, and when the rate is 5%, it means the same business have to pay 5 cents for every dollar. Consequently, a 4% rate is considered cheaper than a 5% rate.
So let us look at a few things that will affect interest rate.
Money, like goods and services, is a form of product supplied by banks and finance institutions to the public. If, for example, the Central Bank increases interest rate then the demand for loans will fall because it has become more expensive to borrow money. This is usually done to slow down problems like inflation, when prices rises too quickly thus distressing the lifestyles of the lower income group. However, the bank must also keep an eye on the job market while doing this, because if entrepreneurs and businesses stop expanding or cut down because loans have become expensive then the job market will be affected.
On the other hand, the Central Bank can also decrease interest rate, which has the effect of reducing the price of a loan. This is usually done when the economy is slow and it needs people to start spending to stimulate it. The reasoning goes that if rates are lowered then consumers will take out loans to buy items like a house, which will become a catalyst to the construction and real estate industry. These firms in turn will also find it cheap to borrow money to employ more people, thus putting in more spending money in the market.
That is how interest rate manipulation is supposed to work in theory. However, individual rates - home loans, car loans, education loans - are dependent on consumer demand as well as their eligibility for the product. For example similar home loans may have different interest rates because one may require that the lender buys an insurance to cover default on the loan, while another demands the home as collateral. The risk of a loan, in terms of the age of lender, collateral, job prospect of lender and number of years on the loan will affect the interest rate attached to it. The more risk a bank has to bear, the higher the rate of interest it will charge.
Another factor that will affect interest rate at this stage is the expected inflation rate. If lenders expect inflation to go up by 2% the following year, then they will add the 2% to their original 4%. Hence the final loan may carry an interest rate of 6% for the borrower. This is because money institutions do not attach value to the numbers, but instead place value on what the amount can buy or its purchasing power. For example, barrel of fried chicken costs $10.00 now but it is expected to increase to $10.20 because of a projected inflation of 2%.
| Current value x (Base year + Inflation rate) | = $10.00 x (1 + 0.02) |
| = $10.00 x 1.02 | |
| = $10.20 |
Hence if the chicken shop continues to sell the barrel at $10.00 the following year, after a 2% inflation, then the real value of the barrel has gone down to $9.80
| Fixed price x (Base year / new rate) | = $10.00 x (1/ 1.02) |
| = $ 9.80 |
For that reason banks or lending institutions will try to project the expected inflation into the loan; else the value of its purchasing power will decrease over time.
The next factor that influences interest rate is market demand. The more people demand money, the higher the interest rate becomes. Applying the logic of the demand-supply curve, when the interest rates for lending go up, more people will be willing to invest or lend their money. This situation usually happens in times of economic growth, so it is actually a fuel that feeds on itself because during times like these, there are more jobs, and people who work get better pay so they have more money to invest. And since corporations are willing to pay big dividends or interest for these kinds of loans, people will put in more money into their portfolio.
Hence one of the most crucial role of the Central Bank is to control the market movement, so that this fragile balance is not disrupted, and the Securities Commission is there to make sure that everyone plays fair because business is built on trust and contract, and if that structure is perceived to be not in place, the market will suffer, a situation that brings us to the next item that affects interest rates.
The fourth factor is how willing people are to 'save' their money in the banks, investment or financial institutions. All monies saved become part of the supply group. Hence during a recession, interest rates may actually rise when people rush to take out their money from the banks, which has the effect of reducing the supply of monies in the market. However, this only happens if the supply drops faster than the demand for monies. In other words, when people stop entrusting their money to financial institutions, bad things begin to happen.
In summary,
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