Interest can be thought of as the cost to borrow money. It is what you pay in addition to the original amount borrowed and t is usually quoted in APR or annual percentage rate. So, if you borrow $1000 and the APR is 10%, you pay $100/year for the privilege. The APR is sort of a misleading figure. If you make monthly payments instead of annual payments, you actually pay more than the $100. Sometimes interest rates will be quoted as the equivalent annual rate. This is the actual interest rate you will be paying. For example, a, 10% APR is about 10.5% terms of an equivalent annual rate, so in our example, we would really be paying close to $105/year for the privilege of borrowing the initial $1000.
Interest rates in the U.S. are guided by the Federal Reserve, often referred to as “the Fed”. They set the fed funds target rate, which is the interest rate they would like depository institutions (mostly banks) to charge each other to borrow. The actual or effective federal funds rate is priced by the market (or the average rate banks actually charge each other. The Fed uses open market operations to influence money supply in order to bring the effective federal funds rate in line with their target rate.
Many lending institutions in the U.S. use the Fed funds rate as a basis for the prime rate. The Prime is what lenders typically charge credit worthy customers and is usually 3% higher than the federal funds rate. The best and most credit worthy customers can usually borrow for less than the Prime rate.
While the Fed Funds rate is recognized as the US benchmark for interest rates, the most globally recognized benchmark for interest rates is LIBOR, which stands for the London Interbank Offered Rate. This is the prevailing interest rate between highly credit-worthy institutions. Many U.S. institutions use this as their base interest rate. Often loan terms qill be quoted with respect to the Prime rate or LIBOR.
Currently, the fed funds effective rate is at historic lows, 12 bps. As a side note, 1 bp equals 1/100 of 1 percent. So 12 bps is 0.12%. The all-time high effective rate was 19.1% back in June of 1981, when the Fed was battling inflation. Have you ever wondered how interest rates are tied to the economy?
Before we get to this, let’s first discuss how banks make money. The basic form of a bank’s business model is to borrow short term, for example they’ll borrow funds overnight at the 12bps/year federal funds effective rate or whatever interest they pay for their bank deposits and lend money longer term, like for auto loans or mortgages. Part of how the banks make money is on the difference between what they borrow for, 12 bps/year for example, and what they lend for, 3.5% for a 30-yr mortgage for example. This is called net interest margin.
Now, let’s circle back to how low interest rates affect the economy. When interest rates are low, banks’ cost to borrow is low and to remain competitive, they pass the lower interest rates on to their customers, individuals and businesses. If they tried to keep interest rates high, their customers would simply go somewhere else with their business. The lower interest rates are, the more likely people are to borrow, since the cost to borrow is relatively low. When people borrow, they tend to spend. The more people spend the more demand there is for goods and services. The more demand there is, the more productive companies have to be to supply the goods and services. Often, to be more productive, companies must higher more employees. More people with jobs means more people with money. More people with money mean more people to spend and more people to borrow. This all acts to pump up the economy and can lead to economic expansion.
An example may help put the low interest rate phenomenon into perspective. Imagine two people, Joe and Sue, are each buying a $400,000 house. They can’t pay cash for the houses, so they apply for 30-yr mortgage. Joe’s quoted interest rate is the current mortgage rate of 4% and poor Sue quoted the all-time high mortgage rate of 18.45% (this occurred in October of 1981). For a $400,000 mortgage, using a 4% interest rate, Joe’s monthly payment would be $2,326.33, for total payments equal to $837,478.03. For Sue, using the 18.45% interest rate, the payment would be $6,690.30 and the total payments would equal $2,408,507.54! Joe would have a lot more money to spend each month on other goods and services and would be better off by about $1.5 million after all the payments were made.
Not so fun fact! The term ‘mortgage’ is derived from ‘mort’ and ‘gage’, meaning ‘death contract’!
As you can see from this example, lower interest rates make big ticket items cheaper in terms of monthly payments and final cost, but there is a dark side. Lower interest rates also create credit inflation. The easier and cheaper it is for customers to borrow, the easier it is for companies and institutions to charge more for their products or services. Do you think a $400,000 house today would cost as much if the interest rate was 18.45% today instead of 4%? No, that would reduce overall housing affordability dramatically. Most likely what would happen is the price of the house would fall toward the monthly payment level under the 4% scenario. The house price would calibrate to the affordable monthly payment of around $2,500. Under the 18.45% interest rate environment, the house would likely price somewhere around $150,000. This is also why school tuition has gone up so dramatically year after year. The cost has increased 5-fold since 1985. A $10,000/year education in 1985 is now $50,000/year. Educational institutions are well aware of the fact that students are able to take on bigger loans and sadly, the schools seem to have no problem exploiting this situation to their advantage.
Remember that a lower interest rate is usually the better option when taking on a loan, so when given the opportunity, try to negotiate the lowest interest rate possible. Lenders may try to make you think otherwise, but they tend to care more about how they’re going to make money off of you. Have you ever gone to buy a car and when negotiating the price, the car dealer asks you whether you care more about the price of the car or the monthly payments? What they are really asking is whether you would rather have a lower interest rate and a shorter payoff period or a higher interest rate and a longer payoff period. For example, a $30k car with loan terms of 5 years and a 4.5% rate would equate to a monthly payment of $559.29 or $33,557 over the life of the loan, and a 7 year loan at 5.5% would equate to a monthly payment of $431.10 or $36,212.51 over the life of the loan. This amounts to a difference of about $2,700. Even though the monthly payment is cheaper under the 7 year, 5.5% loan, the cost is greater. I would prefer the cheaper car, thanks.
Interest rates can affect the affordability of a loan significantly. Be sure to keep in mind the total amount of money you are going to spend on something, not just what the sticker price is or the monthly payment. Nobody likes to overpay for anything.