There are many ways that people and institutions give interest rate definitions, mostly depending on their field of interest, but the long and short of it is that interest rate is what a borrower suffers in comparison to the capital attained. What the borrower suffers is ideally what the lender is foregoing in order to let someone else use the asset.
Simply speaking, you earn a premium for depositing money in a bank fixed account (call it interest) and someone else pays (or suffers) an interest for borrowing the money from the bank. Not that complicated huh? So why do some people and finance publications make it so hard for us average Joes to understand what their talking about and what do interest rates mean to us? Here is your dummies guide for understanding interest rates and how they affect us so you don’t need to carry around an Interest Rate Calculator to understand.
7 understandable facts about interest rates
- For the simple interest rate definition, we shall all be unanimous that it is the percentage charged over a specific period of time.
So that, borrowing $100 for a year at a rate of 5% calls for the borrower to pay $105 after 12 months. But are there other costs involved like cost of stationery? Definitely yes.
- High rates on deposits encourage savings.
Well, that may be the case because people tend to invest where return on investment is high. But surely, will people increase savings when the increased rate of interest is still lower than that of inflation? It’s very unlikely.
- Low interest rates benefit borrowers
In a fair and perfectly competitive market, that will happen automatically. But we are in the real world where commercial banks do not pass on the benefit of low interest rates from the Central Bank to the borrower.
- Low interest rates from commercial banks allow borrowers to pay less.
Good intentions no doubt; but the reality is that more borrowers are lured by the commercial banks without enough due diligence, and the result is increased rate of loan default and late payments, leading to enormous penalties.
- Interest rate is the cost of the loan
Yes, partially so; there is more to the loan cost than interest.
- Cutting interest rate improves the standard of living
Sometimes; but to those living below the poverty line, it just means an additional meal-nothing to do with quality.
- Reducing interest rates improves the economy
Yes-as long as more people can borrow and invest and raise employment levels.
7 myths you probably have heard about interest rates
- High interest rate stifles the economy
Not necessarily true. Exporters earn better for their supplies and improve business.
- Increased interest rates hurt businesses
Well, the lender doesn’t definitely concur with that.
- Increased interest rate is bad for the economy
Not when it discourages importation and encourages local consumption that in turn translates into more job opportunities.
- High interest rates create a poor environment for business
Not always. By discouraging excessive borrowing, they could just be protecting the borrowers from over-investing in infrastructure whose return on investment is uncertain.
- Cutting interest rates results in improved standard of living
The reality is that the low rates may just result in increased consumption and not necessarily investment in shelter, health or education.
- Cutting interest rates improves the economy
Not obvious. The big employer may lose a lot in exports and begin to downsize the workforce.
- Increased interest rates on deposits encourage savings
The depositor is paid from the borrower’s interest; so in the market place, not much changes.
So now are you an expert on Interest Rate definitions?
So amidst all the mumbo jumbo and technical speak what do interest rates mean? And are interest rate definitions useful?
Interest rate for practical purposes is the percentage of loan you are expected to pay with the capital denominator (your take-away) being less all charges and costs involved. Using the example given on simple interest, the effective rate, otherwise known as Annual Percentage Rate (APR) would not be 5% if loan processing fee was $5 and insurance premium $12. It would be about 6%, i.e. [5% of (100-5-12)).
Simple? Complicated? After today’s post do you understand what do interest rates mean or are you still in the dark about Simple-Interest Meaning? Are you now savvy enough to talk to a wall street banker and hold your own?
***Photos thanks to 401 (k) 2013, cogdogblog & Rammiefong***