The term interest rate can refer to something from the Fed Funds rate to Treasury rates or 30-year fixed rate mortgages. Since most of these rates usually move together, the term interest rate can refer to any bank lending rate. However, theses rates don’t always move in tandem because different forces drive them.
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An interest rate is the price set for the transfer of a good or service. Though this may seem an odd definition, it becomes understandable when the good or service being transferred is credit. Interest rates reflect the price paid for the transfer of credit. In these transactions, there is a supplier of the credit and a participant that demands credit. Economically, the interest rate is the cost of capital and is subject to the laws of supply and demand of the money supply.

There are various situations that exemplify this relationship, one such example is when an individual saver supplies credit to a bank. The individual depositor supplies the credit though a money market deposit account or certificate of deposit and the bank is borrowing the money and paying interest to that depositor. The bank in turn supplies this credit to a consumer or business that demands the credit. The business or consumer will now pay interest to the bank for the use of this credit. There are many different forces that contribute to the supply and demand for credit.

Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand.

The general level of interest rates is determined by this interaction of the supply and demand for credit. The price of credit or the interest paid does not necessarily even. Often there are disruptions that shift the supply or the demand for available money. If the supply becomes constrained, rates will rise to reflect the lack of available funds. If demand for credit becomes weak, rates will tend to drop. Other risk factors will influence various segments of interest rate based financial instruments such as; the quality of credit or default risk, liquidity risk, the term structure or maturity. These are factors that affect the interest rate on specific products, the supply and demand for credit set the general level of interest rates.

If all other factors are held constant, an increase in the demand for credit raises the price of credit, or interest rates. A decrease in the demand for credit lowers will lower interest rates. If all other factors are held constant, an increase in the supply of credit will lower interest rates. A decrease in the supply of credit will raise interest rates.

Demand for Credit

There are a variety of sources that may drive the demand for credit. The level and trend of current consumption is the biggest factor influencing the demand for credit. Consumption is the term used by economists to describe spending money on goods and services. There is constant on going consumption by all consumers, businesses, and governments. As these entities increase or decrease their level of consumption they demand credit to purchase goods and services for current use. When loans are made for consumption, borrowers agree to pay interest to a lender or saver because they prefer to have the goods or services now, rather than waiting until some time in the future when, presumably, they would have saved enough for the purchase.

Investment is another force that drives the demand for credit. Here consumers, businesses, and governments borrow funds only if the use of funds is for opportunities that will earn more than the cost of the funds or other activities.

For example, if a widget manufacturer sees an opportunity to purchase a new machine that can reasonably be expected to earn a 10 percent return, the manufacturer will borrow funds only if they can be obtained at an interest rate less than 10 percent.

What borrowers are willing to pay, then, depends principally on time preferences for current consumption and on the expected rate of return on an investment.

Supply of Credit

The supply of credit comes from savings—funds not needed or used for current consumption. When we think of savings, most of us think of money in savings accounts, but this is only part of total savings. All funds not currently used to purchase goods and services are part of total savings. For example, insurance premiums, contributions to pension funds and social security, funds set aside to purchase stocks and bonds, and even funds in our checking accounts are savings. Since most of us use funds in checking accounts to pay for current consumption, we may not consider them savings. However, funds in checking accounts at any time are considered savings until we transfer them out to.

The more banks can lend, the more credit there is available to the economy. And as the supply of credit increases, the price of borrowing (interest) Credit available to the economy is decreased as lenders decide to defer the re-payment of their loans.

The Fed has the responsibility of monitoring and influencing the total supply of money and credit.

When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates then decrease. When the government sells securities, money from the banks is drained for the transaction, rendering less funds at the banks’ disposal for lending, forcing a rise in interest rates.

Credit Demand, Credit Supply and Inflation

Borrowers and lenders, however, are not as concerned about dollars, present or future, as they are about the goods and services those dollars can buy, the purchasing power of money. Inflation reduces the purchasing power of money.

Each percentage point increase in inflation represents approximately a 1 percent decrease in the quantity of real goods and services that can be purchased with a given number of dollars in the future. As a result, lenders, seeking to protect their purchasing power, add the expected rate of inflation to the interest rate they demand. Borrowers are willing to pay this higher rate because they expect inflation to enable them to repay the loan with cheaper dollars.

Interest rates are the rate that determines what borrowers must pay in future dollars to receive current dollars. If a lender expects an eight percent inflation rate for the coming year and otherwise desire a four percent return on their loan, they would likely charge borrowers 12 percent, the so-called nominal interest rate, an eight percent inflation premium plus a four percent real rate.

Borrowers and lenders tend to base their inflationary expectations on past experiences that they project into the future. When they have experienced inflation for a long time, they gradually build the inflation premium into their rates. Once people come to expect a certain level of inflation, they may have to experience a fairly long period at a different rate of inflation before they are willing to change the inflation premium.

Risk Factors In Rates

As with other prices in a free market system, interest rates are determined by many factors. Bank CD rates, mortgage rates, money market account rates and consumer loan rates are all credit transactions that have different interest rates or different prices for credit. General economic conditions, for example, cause all interest rates to move in the same direction over time. Supply and demand are the primary forces behind interest rate levels. Interest markets will also generally look at several factors to determine a rate on any particular loan or asset. The interest rate on each different type of loan depends on the credit or default risk, liquidity risk, duration, interest rate or inflation rate changes and tax considerations of the particular loan. These types of risk factors also help determine rates on bank deposits including CDs and savings accounts.

These factors vary for different kinds of credit transactions, causing their interest rates to differ at any one time. Some of the most important of these factors will be the different levels and kinds of risk with each credit type, different rights granted to borrowers and lenders, and different tax considerations.

Risk refers to the chance that something unfavorable may happen. These are certain well-accepted key factors that explain the rate differences between various loan types. The interest rate on a credit card balance is higher than the rate on a new car loan. One reason behind the difference between the interest that yields a Treasury bond and the interest that yields on a mrtgage loan is the risk that the lender takes from lending money to an economic agent. In this particular case, the US government is more likely to pay than a private citizen. Therefore, the interest rate charged to a private citizen is larger than the rate charged to the US government.

Liquidity risk affects interest rates by mitigating possible future risks. If a security can be quickly sold at close to its original purchase price, it is considered highly liquid. Assets that are easily converted into money is more liquid and generally more valuable than one that cannot be sold at a price close to its purchase price. Therefore, it is less risky than one with a wide spread between its purchase price and its selling price. Liquidity brings down the interest rate that is charged or paid for assets.

Credit transactions usually involve lending or borrowing funds for an agreed upon period of time. At the end of that time the loan is said to have matured and must be repaid.
Time or maturity on a loan is a factor of risk similar to liquidity. The risk involved on the length of maturity is referred to as duration risk. Long-term securities are subject to more risk than short-term securities because the future is uncertain and more problems can arise the longer the security is outstanding. Long-term loans have a longer durations and a greater uncertainty over whether the borrower will be able to repay the loan. In addition, the longer the duration of a loan, the more likely the lender is to desire access to the funds. So, lenders have to be compensated for the greater risk with higher interest rates on longer-term loans. The value of a long-term loan, compared to that of a short-term loan, is further at risk to the effects of inflation. Therefore, the longer the borrower has to repay the loan, the more interest the lender should receive. Similarly, rates paid to depositors will be higher on CDs and bank accounts that restrict access to the funds for longer periods of time.

Default risk can apply to both depositor, loaning funds to the bank as well as the bank that is loaning funds to the individual or business. There is always the risk the borrower will become bankrupt or otherwise default on the loan. The risk that a business or industry could fail. The risk premium attempts to measure the integrity of the borrower, the risk of his enterprise succeeding and the security of any collateral pledged. For example, loans to developing countries have higher risk premiums than those to the US government due to the difference in creditworthiness. An operating line of credit to a business will have a higher rate than a mortgage.

For any number of reasons, even the most well intentioned borrowers may not be able to make interest payments or repay borrowed funds on time. If borrowers do not make timely payments, they are said to have defaulted on loans. All loans are subject to default risk since borrowers may die, go bankrupt, or be faced with unforeseen problems that prevent payments.

Creditworthiness of businesses is measured by bond rating services and individual’s credit scores by credit bureaus. The risks of an individual debt may have a large standard deviation of possibilities. How the loan is secured will have an impact on default risk, the greater the security, the less likely default will occur. Credit and default risk may also encompass economic risk. Economic risk is the risk that the economy will turn down, pulling investment values down as well. Economic risk tends to be a risk that most companies cannot control.

Risks that are the expected future interest rates.The risk that interest rates will rise higher than the fixed rate of interest you are receiving, making your savings or investments less valuable. If you lock into a fixed rate of return right now you may very well experience interest rate risk. Interest rate risk is a most crucial consideration for bondholders. When interest rates go up, bond values in the secondary market will fall, and vice versa. One can benefit from interest rate risk by locking into fixed rate of return investments when rates are at a high point in the interest rate cycle. When you believe we are near the top of the interest rate cycle, you may wish to increase the portion of your portfolio that is committed to lending type investments, such as CDs and bonds.

There are some differences in interest rates that not attributable to these defined risk assessments. Some lenders charge higher rates than other lenders for reasons that determined by risk but market other forces. In other words, while competition eliminates some price differences between similar goods and some interest-rate differences on similar loans or CD rates, it doesn’t eliminate all of them. Some banks will simply offer higher CD rates than other banks. Some urban banks may have less competition and offer lower CD rates than national averages since competition doesn’t warrant increase the rate to lure depositors. The best CD rates are often found in the most competitive banking markets, however as the amount of pricing and rate information becomes easier to obtain, even rural banks most often compete with highly competitive urban markets and thus offer competitive market rates on their products and services.

Inflation risk is the risk of losing purchasing power.

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