What is an interest rate?
The interest rate is the amount that a lender pays for the use of assets. (for example, cash, consumer goods, or even larger assets such as a vehicle or building). In other words, interest is a rental or lending fee that the borrower has to pay for the use of an asset. Thus, the interest rate represents the cost of debt for the borrower and the return for the lender. The interest rate is expressed as a percentage of the principal amount. As a rule, a lower interest rate is charged if the lender classifies the borrower as low-risk. To classify the borrower, the lender analyzes the borrower’s creditworthiness.
The formula for simple interest
Simple interest = principal amount × interest rate × time
Example:
Interest rates apply to most credit and loan transactions. Suppose a private individual takes out a mortgage in the amount of CHF 1,000,000. If the interest rate on the loan is 5%, this means that the borrower will owe the bank the original loan amount (CHF 1,000,000) plus interest of CHF 50,000 (5% * CHF 1,000,000) at the end of the term. This calculation is based on the assumption that the loan agreement is for one year. If the term of the loan is 10 years, for example, the interest payment is calculated as follows:
Simple interest = CHF 1,000,000 x 0.05 x 10
Simple interest = CHF 500,000
Some lenders prefer the compound interest method. The interest owed under the compounding method is higher than the interest owed under the simple interest method. Interest is calculated monthly on the principal including interest accrued in previous months.
Factors that determine the interest rate
The interest rate set by banks is influenced by many factors, such as the economic situation. As a rule, the interest rate is determined by the supply and demand on the money and capital markets, the prime rate, the borrower’s credit rating, the term, the type of loan and the intended use.
The central bank of each country sets an interest rate (prime rate), which each bank uses to determine the range of APRs it offers. If the central bank sets a very high interest rate, it can lead to some individuals and companies deciding not to take out a loan, thus curbing consumer demand. Interest rates can also rise in line with inflation. Inflation can be combated by banks setting higher reserve requirements. This leads to a tightening of the money supply, or an increased demand for credit.
In a high interest rate environment, private individuals and companies tend to save, as they receive more through the interest on savings. The stock market suffers as a result. In addition, companies have limited access to capital financing through debt, which can also have a negative impact on the economy. In contrast, the economy benefits in times of low interest rates. Private individuals and companies receive little interest on savings, which boosts consumption. Riskier forms of investment such as shares are now preferred. Borrowers have access to cheap loans. However, a low interest rate environment can lead to a market imbalance. Demand exceeds supply and causes inflation. When inflation occurs, interest rates also rise.