Interest rates – definition

In simple terms, an interest rate is rate charged by a lender of money or credit to a borrower. In short, from the borrower’s point of view it is the ‘cost’ of borrowing, and from the lender’s point of view it is the reward for lending.  Or, to put it into an even simpler way, the rate of interest is the price of money.

When a loan or credit is made the lender loses ‘liquidity’, and the rate of interest can be seen as the compensation for parting with liquidity, and losing the ability to allocate funds to consumption.

Given the fact that there are many sources of funds for lending and different types of borrower with different reasons for borrowing, there is a complex structure of interest rates in a modern economy.

Although there is no single rate of interest in an economy, there are some principles which help up understand how interest rates are determined.

  1. The demand (preference for) and supply of liquidity.
  2. The length of the loan period (the ‘term’).
  3. The creditworthiness of the borrower and probability of ‘default’.
  4. The purpose of the loan.
  5. The asset or ‘backing’ that might be used as collateral for the loan.
  6. Whether the loan is ‘guaranteed’ by a third party.
  7. The current and expected inflation rate (as this alters the real value of interest rates). Nominal rates are the quoted rate on the loan, such as 4%, whereas ‘real’ interest rates are the nominal rate adjusted for inflation. In simple terms, the inflation rate is deducted from the nominal rate to obtain the real rate. So if inflation is 1% and the nominal rate is 4%, the real rate is 3%.
  8. Subsidies by government, such as subsidies for student loan rates.