Some Prime Stuff On INTEREST RATES
One unexpected benefit from our foot-paced view of the economy is loose change. Keeping our eyes to the ground has uncovered a nickel here, a quarter there, and an occasional dollar bill. My total is up to $137.65, an amount that I'm reluctant to keep on my person. Fortunately Interstate OmniBank has a branch very close the Dr. Nova Cain's dental office. I can deposit my booty into a safe, secure savings account under the watchful eyes of Interstate OmniBank employees, to be withdrawn if needed at a later date. Not only will Interstate OmniBank keep my $137.65 safe and secure, they'll also pay me an interest. That's I deal I just can't pass up.
An Interest Rate Buffet
The amount that Interstate OmniBank pays me for keeping my money safe and secure depends on an interest rate. While it changes from time to time, Interstate OmniBank is currently paying a 5 percent interest rate. That means for each $100 I let them keep safe and secure for a year, they add $5 to may account. For my $137.65, they add $6.88. (Actually the total amount of interest depends on their compounding method -- that is, the number of times during the year that they add interest to my account. To see more on this, check out compound interest.)
The interest rate that Interstate OmniBank pays to keep my money is only one of several interest rates in the economy -- about a gadzillion at last count. You've probably had personal experience with some, no more than a nodding acquaintance with others, and are a veritable stranger to many more. While anything resembling a complete listing would take more time and than we have and, quite frankly, would be as exciting as reading the phone book, a few of the more common ones are: prime rate, rate on Treasury bills, home mortgage rate, discount rate, commercial paper rate, yield on corporate bonds, savings rate, and credit card rate.
The one compelling, overwhelming observation that we can make from noting this myriad of interest rates is that they range far and wide. The Treasury-bill interest rate, for example, might be a paultry 3 percent while the interest rate on your Interstate OmniBank Platinum Diamond Express credit card tops out near 20 percent.
This compelling, overwhelming observation opens up our theme for the next few pages: Why does the federal government pay 3 percent when it borrows to finance the federal deficit, but you pay 20 percent when you borrow using your Interstate OmniBank Platinum Diamond Express credit card? Why do I get 5 percent on my savings account, but pay 10 percent on a home mortgage loan? Why are some interest rates higher than others?
Another Quick Jog through the Financial Markets
Let's ponder the purpose of interest rates to answer these overwhelming and compelling questions. In so doing, we'll also need to trip lightly through the financial markets.
Financial markets trade legal claims on goods or resources in exchange for money. Examples include the stock market, bond market, market for government securities, insurance, and assorted bank accounts. Some people have money that they're willing to trade for legal claims and others have legal claims that they're willing to trade for money. Interest rates are the prices that match up the buyers and the sellers -- lenders and borrowers -- in many of these financial markets.
For example, when my $137.65 of loose change is deposited in the Interstate OmniBank, I become a lender. When you use your Interstate OmniBank Platinum Diamond Express credit card, you become a borrower. In fact, if you charged $137.65 on you credit card, it wouldn't be too far off to say that you borrowed it from me -- with a little assistance from the bank.
The question we need to ask now is: Why am I willing to part with $137.65 and why are you willing to pay for the privilege of charging $137.65 on your credit card?
Those Sacrificing Consumers
An answer to this question comes from a close scrutiny of our preferences for time. Some prefer the present over the future and thus need a high interest to coax them into lending or are willing to pay a high interest for borrowing. Others are a little more inclined toward the future and need a lower interest rate for borrowing and lending.The bottom line on lending is sacrifice -- giving up current consumption. The $137.65 of loose change that I deposit in my Interstate OmniBank savings account could be used for buying stuff that would add to my satisfaction right now. For me to postpone that satisfaction, I need compensation. If I'm willing to lend the Interstate OmniBank $137.65 for one year at a 5 percent interest rate, then I'm willing to forego $137.65 worth of satisfaction this year in order to get an extra $6.88 of satisfaction next year. If I need more than $6.88 worth of extra satisfaction to give up my $137.65 for one year, then I won't lend it to the bank. Lending my loose change to Interstate OmniBank is just like supplying my labor. I'll work for $10 an hour, If I'm willing to give up my leisure for that wage. If I need more than $10 to compensate for my lost leisure, then I won't work.On the other side of the financial markets, borrowers are willing to pay for the privilege of a little extra consumption today. Suppose the $137.65 charge on your Interstate OmniBank Platinum Diamond Express credit card (with its 20 percent interest rate) is for an evening of fine food with four friends at Gary's Authentic French Cuisine and Truck Stop. You willingly give up $27.53 worth of consumption next year (the interest charge) for the privilege of eating $137.65 worth of authentic french cuisine today. Why would you do this? Perhaps you expect to have more income next year than this year, and thus the interest charge will be more easily paid. Or maybe, you're just downright hungry today. Maybe you're so hungry today -- to the point of malnourishment -- that $27.53 a year from now means very little to you. You're willing to sacrifice future consumption to get the food you need to let you live long enough to have a future.
Don't Forget About Investment
Consumers, however, don't do all of the lending and borrowing. In fact, one of the more important reason for borrowing is business investment in capital goods. The interest rate businesses are willing to pay for investment borrowing depends on how much return they receive (or expect to receive) from their capital.
For example, suppose that Gary's Authentic French Cuisine and Truck Stop decides to double its seating so that twice as many fine-food fanciers can fancy fine food -- with an investment price tag of $100,000. Gary, the owner of this fine establishment, would be willing to pay an interest rate up 10 percent if the extra capacity brings in an additional $10,000 per year in profit (which is 10 percent of $100,000).
Slicing the Interest Rate Three Ways (Plus Cost)
We're now to the point where we ca answer the question: Why do I get 5 percent on my savings account, but you pay 20 percent on your credit card?
Every interest rate, whether it's for credit cards, T-bills, or corporate bonds, includes at least three parts (and most have a forth that we'll note momentarily).
Real return. The first and foremost base for every interest rate stems from the consumer time preferences or business investment stuff we just note. In an ideal world (one that doesn't have risk or inflation) the real return compensates consumers for current sacrifices and/or results from the productivity of capital investment.
Risk premium. Unfortunately we don't live in an ideal world -- in part because the future is uncertain. A lender never knows for certain that a borrow will pay off a loan. A lender, therefore, tacks a few extra percentage points -- a risk premium -- onto the interest rate to compensate for this risk.
For example, suppose Interstate OmniBank needs a real return of 10 percent on $1,000 loans to each of 100 borrowers. That is, after one year Interstate OmniBank needs to collect $10,000 in interest on $100,000 in loans. But what if one of those 100 borrowers defaults on the loan, failing to pay off both the original $1,000 loan and the interest? That means Interstate Omni needs to collect a grand total of $11,000 in interest from the remaining 99 borrowers. This is accomplished by charging each borrower 11.11 percent interest rather than a mere 10 percent. The extra 1.11 percent interest is the risk premium. When that one low-life, slim-ball fails to pay up, the bank still gets the needed $110,000 from the other 99.
Inflation premium. Another deviation from an ideal world is inflation. The problem with inflation is that a dollar today isn't worth the same as a dollar next year. In fact, the higher the inflation rate, the less value a dollar has next year. As such, if a lender needs a particular real return on a loan, the interest rate will need to be bumped up to adjust for the rate of inflation.
To see why, let's go back to Interstate OmniBank's 10 percent real return needed on $100,000 worth of loans. The bottom line is that Interstate OmniBank needs to get back $110,000 in one year. Or better yet, Interstate OmniBank needs to have $110,000 in purchasing power in one year. But what if the inflation rate is 5 percent? What if you need $105 next year to buy the same stuff that you can buy this year for only $100? In this case, $110,000 isn't going to be enough. In fact, what you as a lender need to have next year is about $115,500 to compensate you for the 5 percent inflation. As such, you need to charge a 15 percent interest rate -- a 10 percent real return and a 5 percent inflation premium.
Administrative Costs. The fourth factor that we don't want to overlook is administrative costs. One big difference between the interest rate banks pay for savings and what they charge for loans is administrative expenses. To stay in the business of helping lenders and borrowers get together in the financial markets, they hire employees, pay the electric bill, and generate a bit of a profit. Of course, we must not over look that fact that lenders with more market control can also extract extra profit by charging higer interest rates.
Now that we've divided up interest rates into their basic parts, let's consider what sort of tips this offers us for any excursion into the financial markets:
Interest Rate Tips
- Riskier loans carry higher interest rates. If you're a good credit risk and aren't likely to default on a loan, then you should be able to get a low interest rate with a small risk premium. Don't subsidize some low-life who can't pay off a loan.
- Be wary of inflation. No one knows for sure what the inflation rate will be next year, but borrowers and lenders make their guess and add them to interest rates. If the actual inflation rate is greater than what everyone thought it would be, then lenders lose and borrowers win. If the actual rate is less than expectations, then lenders win and borrowers lose.
- Information is a key commodity in the financial markets. Some lenders and borrowers know a lot and others don't. Banks, governments, and business leaders -- card-carrying members of the first two estates -- tend to have more information than consumers of the third estate. They also tend to have more market control. As such, they're likely to overstate risk and inflation premiums if as lenders and understating them if as borrowers.