Interest rate

An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed. Interest rate periods are ordinarily a year and are often annualized when not. Alongside interest rates, three other variables determine total interest: principal sum, compounding frequency, and length of time. Interest rates reflect a borrower's willingness to pay for money now over money in the future. In debt financing, companies borrow capital from a bank, in the expectation that the borrowed capital may be used to generate a return on investment greater than the interest rates. Failure of a borrower to continue paying interest is an example of default, which may be followed by bankruptcy proceedings. Collateral is sometimes given in the event of default. In monetary policy and macroeconomics, the term "interest rate" is often used as shorthand for a central bank's policy rate, such as the United States Federal Reserve's federal funds rate. "Interest rate" is also sometimes used synonymously with overnight rate, bank rate, base rate, discount rate, coupon rate, repo rate, prime rate, yield to maturity, and internal rate of return.

Definitions

Real versus nominal

The nominal interest rate is the interest rate without adjusting for inflation, whereas the real interest rate takes inflation into account. Real interest rates measure the interest accumulated and repayment of principal in real terms by comparing the sum against the buying power of the amount at the time it was borrowed, lent, deposited or invested. Where inflation is the same as nominal interest rate, the real interest rate is zero. The real interest rate is given by the Fisher equation:

r = 1 + i 1 + p − 1 {\displaystyle r={\frac {1+i}{1+p}}-1\,\!}

where p is the inflation rate. For low rates and short periods, the linear approximation applies:

r ≈ i − p {\displaystyle r\approx i-p\,\!}

The Fisher equation applies both ex ante and ex post. Ex ante, the rates are projected rates, whereas ex post, the rates are historical.

Other rates The term "interest rate" is also often used as shorthand for a number of specific rates, most commonly the overnight rate, bank rate, or other interest rate set by a central bank. In this regard, the United States Federal Reserve's Federal Funds Rate is often simply known as the "interest rate" or "rate", due to its global macroeconomic and financial significance. In United Kingdom contexts, Official Bank Rate of the Bank of England is also known as "the interest rate". "Interest rate" is also sometimes used synonymously with base rate, discount rate, coupon rate, repo rate, prime rate, yield to maturity, internal rate of return, spot rate, forward rate, and benchmark rates such as Libor and SONIA. Base rate usually refers to the annualized effective interest rate offered on overnight deposits by the central bank or other monetary authority. The annual percentage rate (APR) may refer either to a nominal APR or an effective APR (EAPR). The difference between the two is that the EAPR accounts for fees and compounding, while the nominal APR does not. The annual equivalent rate (AER), also called the effective annual rate, factors into account compounding frequencies of products, but does not account for fees. Discount rate can both refer to the discount window of central banks and more generally as the annual rate used to discount future values into present value. For an interest-bearing security, coupon rate is the ratio of the annual coupon amount (the coupon paid per year) per unit of par value, whereas current yield is the ratio of the annual coupon divided by its current market price. Yield to maturity is a bond's expected internal rate of return, assuming it will be held to maturity, that is, the discount rate which equates all remaining cash flows to the investor (all remaining coupons and repayment of the par value at maturity) with the current market price. Based on the relationship between supply and demand of market interest rate, there are fixed interest rate and floating interest rate.

Monetary policy Interest rate targets are a vital tool of monetary policy and are taken into account when dealing with variables like investment, inflation, and unemployment. The central banks of countries generally tend to reduce interest rates when they wish to increase investment and consumption in the country's economy. However, a low interest rate as a macro-economic policy can be risky and may lead to the creation of an economic bubble, in which large amounts of investments are poured into the real-estate market and stock market. In developed economies, interest-rate adjustments are thus made to keep inflation within a target range for the health of economic activities or cap the interest rate concurrently with economic growth to safeguard economic momentum.

History

In the past two centuries, interest rates have been variously set either by national governments or central banks. For example, the Federal Reserve federal funds rate in the United States has varied between about 0.25% and 19% from 1954 to 2008, while the Bank of England base rate varied between 0.5% and 15% from 1989 to 2009, and Germany experienced rates close to 90% in the 1920s down to about 2% in the 2000s. During an attempt to tackle spiraling hyperinflation in 2007, the Central Bank of Zimbabwe increased interest rates for borrowing to 800%. The interest rates on prime credits in the late 1970s and early 1980s were far higher than had been recorded – higher than previous US peaks since 1800, than British peaks since 1700, or than Dutch peaks since 1600; "since modern capital markets came into existence, there have never been such high long-term rates" as in this period. Before modern capital markets, there have been accounts that savings deposits could achieve an annual return of at least 25% and up to as high as 50%.

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