- Interest is the extra amount of money a borrower has to pay on top of the loaned amount
- Interest rate is the rate of interest paid over the borrowed amount
- Interest rates can be thought of as “the cost of borrowing”
- Entire economies are affected by changes in interest rates
The talk of the town…a topic that once would have resulted in you being a loner now seems to be on the tip of every investor’s tongue. So what are interest rates?
Rates is a broad term that encompassess a lot of instruments that have to do with paying interest.
Types of interest-rate based securities
The three main categories of rates-based products include Government Bonds, Interest Rates Swaps and Corporate Bonds.
Whilst conceptually different, these types of securities have one key point in common: one party agrees to borrow money for X time and give it back at the end, whilst paying interest in between.
So at the end of the day all rates products are similar to borrowing a personal loan from the bank, paying interest and then giving them back the amount borrowed.
How does interest work
The key metric for these products is the interest rate, which can be thought of as the “cost of borrowing,” aka, the amount you would have to pay on top of the amount you want to borrow.
For example, if you wanted to borrow $100 and the interest rate was 5%, you would have to pay back $105. As the borrower, the interest rate is the cost of debt and for the lender, it’s their rate of return. The lender requires compensation for lending money because they are losing out on investing that money somewhere else (opportunity cost).
On a larger scale, companies need to borrow money from banks to fund projects and hence, interest rates determine how much the company can afford to borrow. As market interest rates increase, it becomes more expensive to borrow money. As a result, it becomes tougher for firms to borrow money and build those projects which accelerate their value.
Without growth, profits are falling which is causing the market value of companies to fall too. The opposite is true too (as you may have noticed post March 2020). With interest rates at almost zero, the market saw a boom in growth as it became very cheap to borrow money, hence allowing the economy to easily grow.
Another catalyst for lowering stock prices when interest rates rise is the increase in demand for fixed income instruments like bonds (because of their less risky nature), which lowers the demand for stocks.
Setting interest rates and fighting inflation
So how are interest rates determined? The central bank (in the US’ case, the Federal Reserve) sets interest rates by taking into account the state of the economy. It is one of the tools used by the government to control people’s spending/saving habits, growth of the economy and overall inflation.
To combat inflation, the FED might increase the reserve requirement for banks which limits the amount of money that can be loaned out and increases the demand for credit. When interest rates are high, people would rather grow their money by saving compared to when interest rates are low, stocks promise better returns than the savings rate (helping boost the economy).
While everyone prefers lower interest rates, this leads to a disequilibrium as demand exceeds supply, and causes inflation. Coupled with a pandemic, this leads to further hiccups in the global supply chain, affecting the entire economy.