What is an Interest Rate?
Where lenders and borrowers meet, interest rates determine the cost of borrowing. The borrower can make use of assets, at a certain cost, expressed as a percentage of the loan, payable to the lender. The costs are calculated by using a fixed rate, variable rate, or a combination of the two and applying compound or simple interest rates.
What are fixed and variable interest rates?
A fixed rate is a set percentage of the loan that is added to the loan, and a variable rate is an interest rate determined by market conditions during the term of the loan. Both only cover the costs of the loss of assets to the lender and compensate for the fact that the lender could have generated an income from these funds. Fixed and variable rates do not include any of the ‘set-up’ or administration costs. Interest can amount to substantial costs for large amounts, and for smaller amounts. Smaller loans are often more expensive than bigger loans when comparing the loan fees to the amount borrowed. The fees mentioned above are not a true reflection of what you will pay when taking out a loan, the APR – or annual percentage rate is a more accurate way of determining the final costs.
Annual Percentage Rate
The APR (annual percentage rate) is the fixed or variable cost combined with all other fees of the loan and is calculated as a variable or fixed rate, with compound or simple interest. Warren Buffet is a famous CEO and once said “everything is a function of interest rates … interest rates are like gravity.” So, it is crucial to understand the payment structure of the intended loan before borrowing money, as the interest can quickly surpass the loan amount and bring a borrower to the knees.
What’s the difference between real and nominal interest rates?
Inflation causes the purchasing power of money to drop over time, and with the aforementioned methods of calculating interest, there have been no adjustments to inflation. The real interest rate can be higher or lower than the nominal interest rate of the contract and is a calculated by subtracting the inflation from the nominal interest rate. This can only be done after the loan has matured and is then called the realized real interest rate.
Why do interest rates change?
Interest rates are low when investors are not afraid of losing money and vice versa. Some factors that contribute to interest rates changing are inflationary expectations, the demand and supply of money in the economy, and international forces. For example a political crisis in an oil producing country or a massive strike in a country that produces natural resources like Gold and Platinum will cause investors to lose money and local currencies to drop. Banks can also play a big role in slowing down or speeding up the economic growth of a country by fluctuating interest rates, which will have an overall effect on the market.