Interest Rate

Interest rate is the monthly effective rate that is paid on the borrowed money for the entire loan period. Interest rate is also expressed as the percentage of the borrowed sum.

For example, for the borrowed amount $1,000, if the interest rate is 6%, then the interest amount for one unit time would be $60.

It can also be said that interest rate is the rate, which is charged or paid for the use of capital or money. Generally, the rate of interest is shown as the annual percentage of the principal amount. The interest rate is determined by dividing the interest amount by principal amount. The interest rates are sensitive to inflation and the policies taken by the Federal Reserve and central banks.

The various factors that determine interest rate are:

Opportunity Cost
Deferred Consumption
Time Length

The opportunity cost gives the second best alternative and covers any other use where the money can be put. The inflation plays a major role in determining the inflation rate. The lenders would want to recover the increased cost of money due to inflation. As the future inflation is never known, the lenders generally take up three steps to cope with the situation. They either charge x% interest plus inflation rate or decide on the expected rate of inflation or allow the rate of interest to be changed periodically.

The lenders are exposed to risk of default as there is always a chance that the borrower may become bankrupt or abscond or even default otherwise on the loan. Hence the rate of interest varies for that of the secured and un-secured loans. The secured loans are given away at lower interest rates for the collateral pledged.

If the rate of interest is same as the inflation rate, then the lender will be left with the same purchasing power in future. The deferred consumption concept says that the lender would prefer his consumption in the present rather than in the future.

The time length of the loan also plays an important part in determining the interest rate. The loans with shorter terms are exposed to less inflation and less risk of default as it is always easier to predict the near future. Hence less interest rate is charged for the loans with short time length.

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Last Updated on : 1st July 2013