Interest Rates: an Introduction

Interest Rates: an Introduction

Interest Rates: An Introduction

Public Information Department
Federal Reserve Bank of New York

April 2004

Interest Rates: An Introduction!

Interest rates receive a lot of attention in the media, but what are they, anyway? How are they determined? What do they do? This introduction provides some basic answers to these questions.

Definition:

  • What is interest?
  • What are APR and APY?
  • Why does interest exist?
  • Interest: cost to some, income to others.

What is Interest?

Interest is the price that someone pays for the temporary use of someone else’s funds. To repay a loan, a borrower has to pay interest, as well as the principal, the amount originally borrowed.

Interest is the compensation that someone receives for temporarily giving up the ability to spend money. Without interest, lenders wouldn’t be willing to lend, or to temporarily give up the ability to spend, and savers would be less willing to defer spending.

Interest rates are expressed as percents per year. If the interest rate is 10 percent per year, and you borrow $100 for one year, you have to repay the $100 plus $10 in interest.

Because interest rates are expressed simply as percents per year, we can compare interest rates on different kinds of loans, and even interest rates in different countries that use different currencies (yen, dollar, etc.).

What are "APR" and "APY"?

"APR" stands for "Annual Percentage Rate," and "APY" for "Annual Percentage Yield."

The APR includes, as a percent of the principal, not only the interest that has to be paid on a loan, but also some other costs, particularly "points" on a mortgage loan.

Points (a point equals one percent of the mortgage loan amount) are fees that the mortgage lender charges for making the loan. In a sense, points are prepaid interest, or interest that is due when the loan is taken out.

Some lenders charge lower interest rates but more points than other lenders. The APR therefore provides a useful gauge for comparing the total cost of mortgage loans.

For example, a 30-year mortgage with an interest rate of 8.0% and four points would have an APR of 8.44%, while a mortgage with an interest rate of 8.25% and one point would have an APR of 8.36%.

The principal used in calculating the APR is equal to the amount of the loan the borrower actually has to use at any time. Consider two one-year loans of $1,000, each with an interest rate of 10%, or $100 in interest.
6 Months / 12 Months
LOAN #1:
$1,000 LOAN / Repay $1,000
Plus $100 Interest
LOAN #2:
$1,000 LOAN / Repay $500
Plus $50
Interest / Repay $500
Plus $50
Interest
The second loan has a higher APR, even though the amount of interest paid ($100) is the same on both loans. The second loan has a higher APR because the second borrower, unlike the first borrower, does not have the use of the entire $1,000 for the entire year, because the second borrower repaid $500 of the loan after six months. (Another reason the second loan has a higher APR is that the borrower paid half of the interest after six months and half at the end of the year, rather than all the interest at the end of the year.)

"APY" is the effective interest rate from the standpoint of a person receiving interest. If you have $1,000 in each of two bank accounts, each paying the same interest rate, but the interest is credited more often (let’s say, every month, rather than once a year) on one of the accounts, that account will have a higher APY, because the interest will build up more rapidly than on the other account.

Why does interest exist?

From the lender’s point of view:

  • Interest compensates lenders for the effects of inflation, or rising prices. Prices go up every year, so lenders are repaid with dollars that can’t buy as much as the dollars they lent; the lenders must be compensated for that loss of purchasing power.
  • Interest also compensates lenders for the risks they take. One risk is that nobody knows for certain how much prices will go up during the time that the borrower has the lender’s money. Other risks are that the borrower won’t repay the loan fully, on time, or at all.
  • For a lender such as a bank, interest covers the costs of staying in business, including the cost of processing loans, and interest also provides the profit that a lender needs to stay in business.

From the borrower’s point of view:

  • Individuals are willing to pay interest to borrow money in order to be able to spend now, rather than later, on cars and many other items.
  • Individuals are willing to pay interest in order to be able to afford a large purchase, such as a home, for which they don’t have enough funds of their own.
  • Individuals are willing to pay interest on loans to pay for education, which can increase their earning ability.
  • Businesses are willing to pay interest in order to borrow to invest in equipment, buildings, and inventories that will increase their profits.
  • Some borrowers are willing to pay interest on certain loans because of the associated tax advantages. Mortgage interest, for example, is tax deductible. That means that in calculating how much income tax you have to pay, you can subtract the mortgage interest that you pay from your income.
  • Banks are willing to pay interest on their customers’ deposits because they can lend the funds at higher interest rates and make a profit.

Interest: cost to some, income to others

Interest is income to people willing to give up the temporary use of their money. When you put money into a bank account, or when you buy a U.S. Savings Bond, for example, you receive interest income.

Interest is a cost to borrowers. You pay interest, for example, if you don’t pay your entire credit card bill at the end of the month, if you take out a mortgage loan to buy a house, or if you own a business that borrows in order to invest in machinery.

Interest is a signal that directs funds to where they can earn the highest rates, or to where loans can do the most for the economy.

Interest is a measure of the cost of holding money. The rate of interest that you could earn by lending your money is the cost to you of holding your money in a way (such as in cash) that doesn’t earn any interest. Economists use the term "opportunity cost" to refer to what you give up by choosing a certain course of action. By holding money, you give up the interest that you could have earned, so the interest rate measures the opportunity cost of holding money.

The Level of Interest Rates:

  • What determines the overall level of interest rates -- that is, why are rates higher at some times than at others?
  • How does inflation affect the level of interest rates?

What determines the overall level of interest rates -- that is, why are rates higher at some times than at others?

Interest is the price of a loan, so it is determined to a large extent by the supply of, and demand for, credit, or loanable funds. Many different parties contribute to the supply and demand for credit.

  • When you put money into a bank account, you are allowing the bank to lend the funds to someone else. So, through the bank, you are contributing to the supply of credit in the economy.
  • When you buy a U.S. Savings Bond, you are lending funds to the U.S. government. Again, you are contributing to the supply of credit.
  • On the other hand, when you borrow -- to buy a car, for example, or by keeping a balance on a credit card account -- you are contributing to the demand for credit.
  • Individual savers and borrowers aren’t the only ones contributing to the supply of, and the demand for, credit. Business firms and governments in this country, and foreign organizations, too, affect the demand for, and supply of, credit.

Together, the actions of all of these participants in the credit market determine how high or low interest rates will be.

All other things held constant, an increase in the demand for credit raises the price of credit, or interest rates, and a decrease in the demand for credit lowers interest rates.
All other things held constant, an increase in the supply of credit lowers interest rates, and a decrease in the supply of credit raises interest rates.
To see how the level of interest rates varies over time, click on

Should the government set ceilings on the interest rates that lenders can charge? For a discussion of the issue, see "Controlling Interest: Are Ceilings on Interest Rates a Good Idea?" available at

How does inflation affect the level of interest rates?

Inflation is one reason interest exists; lenders must be compensated for the decline in the purchasing power of what they lend. So, rates generally are high when inflation is expected to be rapid.

Inflation expectations are based heavily on recent inflation. So, rates generally are high when inflation is rapid.

For a chart showing how inflation and interest rates are related, see page 9 of "Points of Interest," available at .

Different Rates:

  • Why do interest rates on different types of loans differ?
  • How does risk vary among different types of credit?
  • How does the duration of a loan affect the interest rate?
  • How do tax considerations affect interest rates?
  • What other characteristics of a loan affect interest rates?

Why do interest rates on different types of loans differ?

Regardless of whether rates are generally high or low, some rates are higher than others.

The interest rate that you pay on a car loan typically is higher than the interest rate that you receive on an account in a savings bank, for example, and the interest rate on a credit-card balance is higher than the rate on a new-car loan.

Several major factors explain these rate differences: risk, duration, tax considerations, and other characteristics of a loan.

  1. How does risk vary among different types of credit?

One risk that a lender faces is that of not being repaid. The greater the chance that you won’t be repaid, the higher the interest rate you will have to charge as compensation for taking the risk. On the other hand, if a loan involves little risk, you would be willing to accept a lower interest rate. That’s why the federal government can borrow at lower rates than can private parties. People are sure the government will pay its debts.

To see how much lower the interest rate is on government borrowing than on borrowing by a corporation, go to and examine the chart titled, "Long-Term Interest Rates."

Some lenders reduce the risk of losing what they have lent by requiring the borrower to pledge collateral, property that the lender can take possession of if the borrower doesn’t repay the loan. The risk is smaller in such "secured" loans than in unsecured loans, so the interest rates are lower, too. Auto loans, for example, carry lower rates than credit-card loans, because the lender can take possession of the car if the borrower fails to pay.

When you apply for a loan, you often have to fill out a form on which you provide information that the lender can use to determine how likely you are to be able to repay the loan. Similarly, there are business firms that rate the creditworthiness of individuals, other firms, and even governments; lenders use this information to determine what rates to charge on loans.

  1. How does the duration of a loan affect the interest rate?

The longer the duration of a loan, the more likely the lender is to desire access to the funds. So lenders typically have to be compensated with higher interest rates for parting with their funds for longer periods.

The longer the duration of a loan, the greater the uncertainty over whether the borrower will be able to repay the loan. So, lenders have to be compensated for the greater risk with higher interest rates on longer-term loans.

Inflation is a major factor determining the level of interest rates. The longer the duration of the loan, the greater the risk that inflation can accelerate, reducing the purchasing power of the loan repayment. So, rates generally are higher on long-term loans than on short-term loans, because people who lend for longer periods have to be compensated for the risk that inflation might accelerate during the longer periods.

A "yield curve" shows how interest rates vary by the duration of a loan.
Short-term rates occasionally are higher than long-term rates. When that happens, economists worry about a possible recession, or a downturn in the economy. For a discussion of the meaning of such an "inverted yield curve," click on
  1. How do tax considerations affect interest rates?

If you receive interest income, you are more concerned with how much of the income you can keep than with how much the borrower pays. You are concerned with after-tax income -- that is, the interest you receive minus any taxes you have to pay on that interest.

Interest on some types of loans has some tax advantages. Interest on loans to state and local governments is exempt from the federal income tax, and interest on loans to the federal government (such as the interest you receive on U.S. Savings Bonds) is exempt from state and local income taxes. These tax advantages help governments borrow at lower interest rates than individuals or businesses.

  1. What other characteristics of a loan affect interest rates?

When you put money into a bank account, you are allowing the bank to use the money. There are different types of bank accounts, though, and they pay different rates of interest. An account that allows you to write checks, for example, provides you with a benefit, so it pays a lower rate than a savings account, which does not offer this benefit.

If you agree to leave your funds in a savings account for a specified time – two years or five years, for example – you are providing the bank with some benefits. The bank knows for certain that it will keep your deposit, and it knows it can use the funds longer than if you had deposited them in, say, a checking account. In return, the bank will pay you a higher rate than on an account from which you can withdraw your funds at any time.

Suppose you lend to someone and suddenly you need the money back. It would be advantageous to you to be able to convert the loan into money quickly and without losing much of what you have lent. Loans that can be converted into money quickly and without a loss (either because you can demand that the borrower repay the loan at any time or because you can sell the loan to someone else) carry lower rates than other loans.

For a more detailed discussion of how interest rates are determined, see "Points of Interest," published by the Federal Reserve Bank of Chicago, available at
There are some differences in interest rates that not atttributable to any of the reasons we have discussed. Just as some stores charge higher prices than other stores for the same items, some lenders charge higher rates than other lenders. In other words, while competition eliminates some price differences between similar goods and some interest-rate differences on similar loans, it doesn't eliminate all of them. So, if you are going to borrow, it might be a good idea to "shop around" to learn what interest rates different lenders charge. For a useful guide to credit card use, click on www.federalreserve.gov/pubs/shop.
Banks charge higher interest rates on the loans they make than they pay on deposits. They do that in order to make a profit. So, why can't people cut out the bank as an intermediary and do the lending themselves, at the higher rates? There are several reasons:
  • As an individual, you may not be able to find anyone who wants to borrow the amount you want to lend. Banks, though, can combine many people's funds to lend borrowers the amounts they want to borrow.
  • As an individual, you may not be able to find anyone who wants to borrow for precisely the amount of time you want to lend. Banks. though, always have new deposits coming in, so they can lend for as long a period as people want to borrow for.
  • Banks are much better than individuals at determining which potential borrowers are likely to repay loans, and which aren't.

Mortgages:

  • Why are mortgage rates important?
  • How do fixed-rate mortgages work?
  • When does it pay to refinance your mortgage?
  • How do adjustable rate mortgages work?

Why are mortgage rates important?

Two-thirds of U.S. households own their own homes (as opposed to renting), and most homeowners pay a mortgage. Thus, the level of mortgage rates determines how much all these homeowners have left to spend on other things. How much people can spend on other things, in turn, affects the overall economy.