Interest rates are a way of defining how much money someone will pay the lender in addition to the loan amount. That is to say, at their core interest rates compensate someone for taking a risk when lending money to someone else.
Interest Rate Basics
If you want to borrow money from a person or organization (e.g. a bank), there is a chance that you will not pay back that money. This doesn’t mean you have any bad intentions when you borrow the money – it just means that sometimes life doesn’t go as planned. Maybe you borrowed the money to start a business and then that business fails. If you cannot pay back the money that you borrowed, the person that lended you that money does not get their money back. To compensate for the risk that they might not get all – or any – of their money back, lenders (people or organizations that lend money) charge interest to borrowers.
This interest – or money to be paid back in addition to the “principal” or initial loan amount – is often expressed as a percent of the initial loan amount. If a lender is willing to give you $1,000 if you pay back $1,100, then they are loaning you $1,000 plus charging $100 in interest. That $100 is 10% of the $1,000 initial loan amount, so that is expressed as charging 10% interest for the loan.
The Role of Interest Rates
Interest rates are used to balance supply and demand in the market for loans. If there are a lot of people willing to lend you money, you have a lot of choice in who you go to for a loan. If Bank A offers you 10% interest on a $1,000 loan while Bank B offers you 5% interest on a $1,000 loan, then you have a choice: do you want to pay $100 in interest to Bank A or $50 in interest to Bank B? While this is a simplified example, most people would choose Bank B.
You can think of interest rates as the “price” of getting a loan. When interest rates are lower, that loan is less expensive to you.
Over time, a lot of people will choose Bank B as their lender instead of Bank A. In order to stay competitive, Bank A will have to lower their interest rate to match Bank B or they will go out of business.
Factors Influencing Interest Rates
As we described in the previous example, interest rates can be used to balance supply and demand for loans. This means that a wide variety of reasons can influence interest rates:
- How many banks / organizations / individuals are providing loans: When there are a lot of people lending money, borrowers will have more power to choose the lowest interest rate options. If there is only one bank that can lend money, then they can charge higher interest rates because the borrowers don’t have other options.
- How many people are looking to borrow money: When a lot of people are looking to borrow money, lenders can charge higher interest rates. Even if one person is not willing to pay 10% interest, there might be another person who is willing to take that loan. If there are very few people looking to borrow money, lenders do not have as much leverage to charge high interest rates.
How risky a borrower is perceived to be: Risk can be related to a number of factors. If someone has a long track record of paying back other loans on-time and in full, banks see them as being trustworthy (or “creditworthy”) are more willing to lend to them at lower interest rates because they expect to get back their money. On the other hand, if someone is borrowing money who has never borrowed money before and banks are worried about them paying back the loan, the bank may charge them a higher interest rate to compensate for that risk.
