Interest Rate
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What is an Interest Rate?
The interest rate is the amount that a lender charges for the use of assets (such as cash, consumer goods, or even larger assets such as a car or building). In other words, interest is the fee that the borrower must pay for the use of an asset. The interest rate represents the cost of debt to the borrower and the return to the lender. Interest rates are expressed as a percentage of the principal amount. The lender typically charges a lower interest rate if the borrower is classified as a low-risk borrower. The lender evaluates the borrower's creditworthiness in order to classify the borrower.
The Interest Formula
Simple Interest = Principal Amount × Interest Rate × Time Period
Example:
Most credit and loan transactions are subject to interest rates. Consider the case of an individual who takes out a mortgage for CHF 1,000,000. Accordingly, if the interest rate on the loan is 5%, the borrower will have to repay the bank the original loan amount (CHF 1,000,000), plus interest of CHF 50,000 (5% x CHF 1,000,000). This calculation is based on the assumption that the loan agreement will last for one year. As an example, if the loan term is 10 years, the interest payment will be as follows:
Simple Interest = CHF 1,000,000 x 0.05 x 10
Simple Interest = CHF 500'000
There are some lenders who prefer the compound interest method. When compound interest is used, the interest owed will be higher than when simple interest is used. The interest is calculated at the end of each period on the principal, including the interest accrued in the previous periods.
Factors that Determine the Interest Rate
Many factors influence interest rates set by banks, such as the economic environment. The level of interest rates is generally determined by the supply and demand on the money and capital markets, the prime rate, the creditworthiness of the borrower, the term, the type of loan, and its intended purpose.
An interest rate (prime rate) is set by the central bank of every country, which is used by the banks to determine the range of interest rates they offer. It is possible that individuals and businesses may refrain from borrowing if the central bank sets a very high interest rate, thereby slowing consumer demand. It is also possible for interest rates to rise as a result of inflation. Banks can fight inflation by increasing reserve requirements. Money supply tightens, or credit demand increases.
When interest rates are high, individuals and businesses tend to save because they are able to earn a higher interest rate on their savings. Therefore, the stock market suffers. Additionally, companies have limited access to capital financing through debt, which can negatively impact the economy as well. Low interest rates, on the other hand, are beneficial to the economy. Savings are not rewarded with interest, resulting in higher consumption by individuals and companies. Investments in riskier forms of capital such as equities are now more popular. Credit is available at a low cost to borrowers. An environment in which interest rates are low may, however, result in an imbalance in the market. Inflation is caused by an excess of demand over supply. Inflation causes interest rates to rise as well.
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