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| About Interest Rates |
In our everyday life we keep hearing interest this, interest that. But how many of us ever thought about what interest is?
From a borrower’s perspective interest is the difference between the amount of money borrowed and the amount of money
repaid. While repaying the debt a borrower incurs so called interest expense. On the other hand, the money landing party
earns interest revenue. Thus, in any particular lending situation interest revenue equals interest expense. The formula
used to calculate the amount of interest is as follows:
Interest = Principal * InterestRate * Duration
where:
Principal - amount of money borrowed
InterestRate - percent paid or earned per year
Duration - number of years
For example when someone acquires a good or service and in exchange promises to make a series of payments to the
supplier he or she enters a transaction called annuity. An annuity is a series of payments of equal amount separated by
equal time intervals.
Lets consider borrowing transactions in which the present value of the future cash flows and the transaction duration or the
number of payments are fixed. A 30 year home mortgage or a 4 year car loan, for instance, are types of such transactions.
In such cases an increase in the interest rate, according to the formula, increases the amount of each payment to keep the
value of the future cash flows unchanged.
There are several well-known types of lending interest rates: discount rate, prime rate and consumer rates for autos or
mortgages.
The discount rate is the rate that the Federal Reserve Bank (the central bank of the United States) charges to banks and
other financial institutions to borrow short-term funds directly from the central bank. The discount rate affects the rates
these financial institutions then charge to their customers.
The prime interest rate is the rate charged by banks and large commercial institutions to their most creditworthy customers
which typically are large and well established businesses. Most major banks have very similar prime interest rate and they
adjust it at the same time. This rate is based on the federal funds rate, which is charged by banks to other banks needing
overnight loans to meet reserve requirements. The federal fund rate is one of the most sensitive indicators of the direction
of interest rates since it is set daily by the market. The prime rate is the most widely used benchmark in setting home equity
lines of credit and credit card rates.
Consumer interest rates represent the rates at which banks and other financial institutions lend funds to individuals like
you and me. Amongst other things consumer rates encompass such familiar things as mortgage rates, auto loan rates,
credit card rates etc. Consumer interest rates are in large degree determined by the prime rates. While the prime rate is not
available to consumers, some consumer loans such as mortgage lines of credit are priced at prime rate + 2%; that is, a
consumer will pay 2 percent over the prime rate to borrow money.
When the Federal Reserve raises the discount rate, typically banks raise the prime rate, which in turn causes consumer
rates to go up resulting in people like me and you paying higher interest rates on our debt.
From a borrower’s perspective interest is the difference between the amount of money borrowed and the amount of money
repaid. While repaying the debt a borrower incurs so called interest expense. On the other hand, the money landing party
earns interest revenue. Thus, in any particular lending situation interest revenue equals interest expense. The formula
used to calculate the amount of interest is as follows:
Interest = Principal * InterestRate * Duration
where:
Principal - amount of money borrowed
InterestRate - percent paid or earned per year
Duration - number of years
For example when someone acquires a good or service and in exchange promises to make a series of payments to the
supplier he or she enters a transaction called annuity. An annuity is a series of payments of equal amount separated by
equal time intervals.
Lets consider borrowing transactions in which the present value of the future cash flows and the transaction duration or the
number of payments are fixed. A 30 year home mortgage or a 4 year car loan, for instance, are types of such transactions.
In such cases an increase in the interest rate, according to the formula, increases the amount of each payment to keep the
value of the future cash flows unchanged.
There are several well-known types of lending interest rates: discount rate, prime rate and consumer rates for autos or
mortgages.
The discount rate is the rate that the Federal Reserve Bank (the central bank of the United States) charges to banks and
other financial institutions to borrow short-term funds directly from the central bank. The discount rate affects the rates
these financial institutions then charge to their customers.
The prime interest rate is the rate charged by banks and large commercial institutions to their most creditworthy customers
which typically are large and well established businesses. Most major banks have very similar prime interest rate and they
adjust it at the same time. This rate is based on the federal funds rate, which is charged by banks to other banks needing
overnight loans to meet reserve requirements. The federal fund rate is one of the most sensitive indicators of the direction
of interest rates since it is set daily by the market. The prime rate is the most widely used benchmark in setting home equity
lines of credit and credit card rates.
Consumer interest rates represent the rates at which banks and other financial institutions lend funds to individuals like
you and me. Amongst other things consumer rates encompass such familiar things as mortgage rates, auto loan rates,
credit card rates etc. Consumer interest rates are in large degree determined by the prime rates. While the prime rate is not
available to consumers, some consumer loans such as mortgage lines of credit are priced at prime rate + 2%; that is, a
consumer will pay 2 percent over the prime rate to borrow money.
When the Federal Reserve raises the discount rate, typically banks raise the prime rate, which in turn causes consumer
rates to go up resulting in people like me and you paying higher interest rates on our debt.
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