Understanding of Interest Rate

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Interest is the payment for current rather than future command over resources, or the cost of obtaining credit. Also, it is the return paid to owners of financial capital.

A. Interest and Credit:
Variations in the rate of annual interest that must be paid for credit depend on the following factors.

1. Length of Loan: In some cases, the longer the loan will be out¬stand¬ing, other things being equal, the greater will be the interest rate charged.

2. Risk: The greater the risk of non-repayment of the loan, other things being equal, the greater the interest rate charged.

3. Handling Charges: The larger the amount of the loan, the smaller the handling (or administrative) charges are as a percentage of the total loan and, other things being equal, the lower the interest rate.

B. What Determines Interest Rates?:
The equilibrium of supply of and demand for loanable funds determine the rate of interest.

1. The Supply of Loanable Funds: The sup¬ply of loan¬able funds depends on individu¬als' will¬ingness to save. The sources of loanable funds are:

a. Household savings-the parts of personal income that people save for children, retirement, rainy days, and for other purposes.

b. Business savings-part of the profits that businesses decide to reinvest (retained earnings) in their own or other businesses.

c. Government funds-part of government's budget surplus or tax receipts, to provide student loans, investment in national infrastructure or just to pay its bills.

d. Foreign countries have also now become a major source of loanable funds that find U.S.A. an attractive place to invest their surplus capital.

2. The Demand for Loanable Funds: The sources of demand for loanable funds are:

a. Consumer Demand for Loanable Funds: In gen¬eral, consumers demand loanable funds because they prefer earlier consumption to later consumption. Consumers' demand for loana¬ble funds is inversely related to the rate of inter¬est.

b. Business Demand for Loanable Funds: Business¬es demand loanable funds to make invest¬ments they believe will in¬crease productivity or profit. The demand curve for loan¬able funds by firms for investment negative¬ly sloped.

c. Government Demand for Loanable Funds: Governments demand loanable funds to cover deficits.

Consumer demand for loanable funds rises for durable and luxury goods when they feel economically secure and, thus, their borrowings against their home equity tends to rise. The government has to borrow during slow economy or to meet expenses for natural disasters and wars.

Any change in the supply of and demand for loanable funds would bring a change in the rate of interest. Moreover, central bank of a country, such as Federal Reserve System, can also take steps to change the rate of interest as discussed in a separate article.

C. Real Versus Nominal Rates:
The market rate of interest expressed in terms of today's dollars is the nominal interest rate. The real rate of interest is obtained by sub¬tracting the antici¬pated rate of inflation from the nominal rate of inter¬est.

For example, if the banks are charging the borrowers a 12 percent rate of interest and the expected rate of inflation is 5 percent, then the real rate of interest is 12% - 5% = 7 percent. At times we earn a negative rate on loans when the rate of inflation is higher than the interest people earn on certificates of deposit or savings accounts.

E. The Allocative Role of Interest: Interest is a price that allo¬cates loanable funds to consumers and to business. Investment or capital projects with rates of return higher than the market rate of interest in the credit market will be undertaken. The interest rate, thus, allocates loanable funds to industries whose investments yield the highest returns and where resources will be the most productive.

Consumers borrow to finance their urgent needs including a "long-term investment" for purchasing homes and automobiles common in Western nations. However, consumer loans in Pakistan are hard to obtain unless the borrowers can offer a tangible collateral.

Consumers borrow to finance their urgent needs including a "long-term investment" for purchasing homes and automobiles common in Western nations. Since the beginning of the wars in Iraq and Afghanistan and increased expenditure on national security, the federal government has borrowed heavily with annual budget deficits rising above $600 billion. The total national debts is now above $10 trillion and rising.

 

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