Interest rates: An Introduction

2007-03-08 10:33:40

( Financial )



Although the interest rate is one of the most important concepts in the world of finance, it is actually quite easy to understand. The interest rate is simply the price that someone pays for the use of money he does not actually own. In other words, it is the cost of borrowing money; it is also the rate of return that a lender receives by letting the borrower utilize his funds.

Interest rates are at the core of most financial transactions. It is also one of the primary tools in managing the economy. Important economic variables such as inflation rates, unemployment levels, and investment opportunities are all affected by prevailing interest rates.

You probably first encountered the concept of interest rates when you opened a savings account. If you have such an account, you know that the bank pays you a certain rate for letting them “hold” your money; that is an example of savings account interest rates. But did you ever wonder what they do to your money once it is deposited? Banks make money by using yours; they lend it out hoping to make profit. Usually, the rates at which banks lend money will exceed the rates they pay to depositors.

The interest rate is also a very important factor to consider when investing. The profitability of investing instruments such as stocks and bonds can ultimately depend on the prevailing interest rate, so be sure you know how the rate is moving. Money markets, currency markets, and futures markets are also very much intertwined with the interest rate.

Interest rates levels take many factors into account, but the primary consideration is the risk involved. In investment instruments like stocks and junk bonds, which are quite risky, the rate of return is often higher to compensate for the possibility of losing money. Relatively risk-free investments like government bonds and Treasury bills, on the other hand, offer lower rates of return.


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