Interest Is The Backbone Of Modern Economy

Sat Dec 5, 2009, 1:41 am | 23 Comments

In modern world, especially the Western world and Japan, interest rate is considered the backbone of modern finances and that includes your family finances as well. It affects and impacts us all in every walk of life. Individuals and families ought to understand its importance.

In the following post, I have attempted to explain what interest rate is, why it is changed and what effect does it have on us all.

The interest comes into play when we borrow money or lend money. Directly or indirectly – when we know it and when we don’t realize it – we can be a borrower or a lender or both. We are all affected when the interest rate goes up or when it comes down. This backbone of the economy is controlled by the central bank of a country. In the U.S., it is called Federal Reserve Bank, commonly known as the Fed.

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You are a borrower and a lender
You can be a borrower or a lender of the money or you can be both. Many of us belong to both groups.

  • You are a borrower

    You are a borrower when you borrow money from an individual like a friend or relative. In probably 99% of cases or maybe more, there is no cost to you. You pay back the principal amount at some time in the future the two parties have agreed on beforehand. Your lender here is not in the business of making money so there is no interest attached with the principal when you pay it back.

    You borrow money from an institution such as your neighborhood bank which charges a certain percentage of your loan on top of the principal you have borrowed. The reason they charge you extra because they are in the business of making money. That’s their bread and butter and it is called the cost of capital or interest.

    If you think about it, in Western world at least, interest affects every part of your financial life. When you become a borrower, these interests have direct impact on your household budget. You pay interest on a home mortgage, auto loan, or credit card bill.

  • You are a lender

    If you are a lender, interest rates determine a portion of your income. Now how can you be a lender and make money? You lend money to a friend or relative, you don’t charge interest on the loan. They didn’t charge you so why should you?

    You may not think of yourself a lender, but if you own bonds, you are, in essence, lending your hard-earned money to the U.S. government – through Treasury bonds and U.S. Savings Bonds, state and local governments and agencies – via municipal bonds.

    You can also lend money to businesses – through corporate bonds. And you know what? They pay you interest on the money you buy their bonds with. So you make some extra money on the principal that you lent to others.

    There are corporate bonds that you don’t make whole lot of money in interest. For example, at times, Lehman was the darling of Wall Street but Lehman, of course, filed for bankruptcy recently – so those bonds may return something, but not as much as people thought they would get.

  • You think you are neither?

    Well! Think again. Even if you are neither a borrower nor a lender, the cost of borrowing money is built in the price of almost any product or service you buy. That’s why interest rates are a key indicator of the health of nation’s economy. It has a direct or a definite indirect impact on your financial life.

    For example, TigerDirect sells computers and a whole lot of other items. They have merchandise in inventory sitting in storage somewhere. They have borrowed money from banks in order to buy parts and systems. They pay interest on that borrowed money. And you, as customer, must pay a part of that interest when you buy that merchandise.

    Similarly, TMI Wireless is such a company where they sell cell phones and accessories. They charge you the price that includes the interest on the money they borrowed from banks.

    Take a look at Money and Investing.

 

A few key rates can give clues about your own interest rates
If you borrow from a friend or relative, your good standing with them is enough and you pay the money with no interest. However, you borrow from a lending institution, there is always an interest attached with the loan.

  • Interest rate on credit cards is tied to the prime rate, which is the rate banks charge for unsecured business loans.

  • Interest rate on mortgage is closely related to the yield of the 10-year Treasury note.

Unsecured loan

The real meaning of an unsecured loan is that it is not backed by any object of value and is lent to you based on your good name. There is no collateral attached with it. When you use your credit card, you borrow or rent money and you have to return it with interest at some point.

Credit card companies don’t ask for any collateral from you. It is your good name. More precisely, for financial institutional purposes, they may want to look at your credit score because they are not your friends and it is strictly a business transaction.

Therefore, your good name may be associated with your historical payment history on prior debt, reflecting in your credit score. In any case, it is your good name that you have created for yourself over the years.

There are three types of unsecured loans.

  • First there is a personal unsecured loan, meaning a loan that you individually are responsible for the repayment of.

  • Second is a business unsecured loan which leaves the business responsible for the repayment.

  • Finally there is a business unsecured loan with a personal guarantee. With this loan, although the borrower is the business, you as an individual will be the payer of last resort if the business defaults on the loan.

  • Recently, some Swedish banks had age limits for older adults seeking unsecured loans. A public outcry led at least one bank to change its policy. The banks said that age group is high risk for this type of loan. An official of one bank said, “However much we may wish it were different, we know that the risk that we are going to die or seriously ill increases sharply with age.”

Secured loan

It is the kind of loan that has some kind of collateral object of value attached with it. Mortgage loan is one. Your home is your collateral. If you get to be behind a few payments and you are unable to pay your monthly installment, then the lending company can repossess your home.

A secured loan is a loan in which the borrower pledges some asset as collateral for the loan. Thus, the creditor, to her advantage, has secured the loan. In the event that the borrower defaults, the creditor takes possession of the asset used as collateral. She can sell the asset to satisfy the debt by regaining the amount originally lent to the borrower.

 

Types of interest rates
In the U.S., the Fed is responsible for keeping up the national economy running. It has a vital role in maintaining the health of the U.S. economy. The ways the Fed does so is by controlling different types of interest rates, depending on a variety of circumstances.

  • discount rate

    This is actually the interest rate the Fed charges banks, including probably your neighborhood bank, on loans made to its member banks.

    These days, the economy is sluggish. I think it has been called a lousy economy. In circumstances like these, the Fed can lower the discount rate and when it does, it creates somewhat of a ripple effect throughout the banking system. The lower rates make loans more affordable for its banks and in turn for the general populace.

    That means a business can borrow money from its bank at a lower rate to boost its production to meet the demand of its products. That in turn creates more jobs.

  • federal funds rate

    It refers to the interest rate banks charge each other for overnight loans. This loan has to be $1 million or more. But this type of interest rate can change very rapidly. It is also known as volatile interest rate.

    A banker wakes up in the morning and the night before she needed at least a million dollars. So today she asks another bank to lend her bank the money. The interest on this kind of loan changes daily in response to the borrowing bank’s need.

  • “effective rate”

    Remember Japan’s zero interest rates? America is almost there too. Since October 29th 2008, the target for the federal funds rate has been at 1%, but the rate at which funds actually change hands, known as the “effective rate”, has averaged around 0.25%.

For example

At some point, the Fed determines that the economy is doing great. More and more people can borrow money at the lower rate. The economy is in full swing. Employment situation is just great. More and more people have obtained jobs. However, it is like you put a car in neutral on a downhill path and if you don’t apply breaks, you will most probably get into an accident.

So what the Fed does is raise the discount rate so that more and more businesses and the general populace, eventually, will have harder time to get a loan. This slows down the economy a little which in turn will lower the inflation rate. There will be some job loss eventually. But as far as the Fed is concerned, that’s probably OK.

The Fed as juggler

This way the Fed acts like a juggler. It is like a trapeze in a circus. The Fed has to keep the economy somewhere in the middle so that enough people will have jobs but not every human in the land who can work. 100 % employment is not good either for the economy. The Fed has to check the inflation rate as well. It has been said by the experts that at any time, the economy would be at its peak if the unemployment rate is above 2% but maybe below 4% or even 5%.

 

Inflation and interest rates are closely related
A time comes in the national economy that it can become overheated. That means that there is more and more demand for goods and services than businesses can meet. More and more people are employed. People, then, have more money to spend. The economy is in full swings. I am using the word or rather the concept “more” so often, it reminds me of the good old days.

This activity can result in higher inflation. Now that, eventually, can damage your pocketbook. Higher inflation also damages the economy by reducing the purchasing power of a dollar.

One of the Fed’s most important job is to keep inflation in check. And for that, one of its key tools is the discount rate. The Fed determines that businesses and families should have harder time to get loan from their banks to slow the economy and eventually lower the inflation.

So the Fed raises the discount rate, thereby, increasing the cost of borrowing which will start slowing the economy. And thus, this action by the Fed dampens the threat of higher inflation.

The reverse is true as well. Lowering the discount rate reduces the cost of money to banks, thus facilitating businesses and families to be able to borrow more money. That in turn, stimulates the economy.

 

What are long-term and short-term rates?
When you borrow money, you, in essence – in effect, “rent” money for a period of time. You don’t outright own the money. You use it to your advantage but you have to give it back to the lender at the end of a specified, mutually agreed upon, period. The longer the period, the more rent you have to pay.

That, in simple terms, is why longer-term loans usually come with higher total interest. For example, you borrow $10,000 from the bank for 10 years at the interest rate of 10%. After 10 years, your total accumulated interest plus principal will be more than if you borrowed that $10,000 for 5 years at the same interest rate of 10%.

However, it so happens, that sometimes long-term rates are less than short-term rates. This is, then, known as an inverted yield curve. What does it mean? Who knows? Even the experts are divided. They cannot agree on the definition of it, let alone explain it to us folks.

Some economists say it warns us that an economic recession is on the horizon and we better be ready for it. That means someone responsible sitting in the high chair must do something at the very first signs of a recession.

There are those who disagree. They say that this phenomenon – inverted yield curve – is a unique combination of certain economic circumstances. When I hear something like this, it reminds me that these so called experts don’t understand it. They don’t get it.

They don’t have a complete grasp of the situation. So they say that these circumstances are unlikely to prove harmful to the economy. They wait and wait and in the process, close their eyes to the coming bad times.

I don’t know about you but I have a strong feeling that the second type of experts are in control of the economy. It looks that way and that probably is the reason we are in this mess altogether.

 

A wrap up of the interest discussion
This is the last post in the interest series. Like I said in a previous post, the interest can be considered the backbone of the Western modern economy. It is like fire. It can do wonders for you if you are careful with it. As long as you are in control, it will obey you and you can lead a good financial life.

However, if you let interest run your life and you let it have control over you and your family, then it can break you and it can break you pretty well.

When you borrow money to buy a house, for example, mortgage experts tell us the first 10 years or so, you pay more than 90% of monthly payment in interest and the rest 10% or in some cases, even less, goes into your home equity. The interest goes straight to the lending company.

If it was just principal and no interest, then you would pay your mortgage a lot faster. The same is true for credit card loan, student loan and even the loans that you can definitely live without. They all carry interest and in case of credit cards a heavy and very heavy interest rate to the tune of more than 20%.

Debt is not something very bad. Handled carefully, it can do wonders for your family and your business. It is one important component in the big picture of the national economy. It is good for expansion of factories, creating more jobs and handled sensibly, it can be the livelihood of a vibrant economy.

The interest rates you actually pay depend on a variety of factors

The following are some of the factors that the interest rates you actually pay depend on:

  • The more risk lenders take on, the higher the interest rates they will charge. That’s why borrowers with spotty credit histories pay higher interest rates than those with good credit.

  • Another key factor is the quality of the asset you are financing. A house tends to rise in value over time. If you default on your loan, the lender can foreclose and usually recover most or all of its money. That’s why mortgage rates are among the lowest available to consumers whereas credit card loan carries the highest interest rate.

    However, on the same token, a car tends to lose value as it ages and, over time, can become worth less than the value of the loan. That means a higher risk of loss for the lender, which is often reflected in a higher interest rate.

Fixed-rate and adjustable-rate loans react differently to changes in interest rates

These two kinds of loans act differently when there are changes to interest rates.

  • When interest rates are rising, you may be better-off with a fixed-rate loan. That way, your interest costs are locked in as the cost of borrowing increases, meaning interest rate.

  • Interest payments on adjustable-rate loans rise and fall along with the general level of interest rates.

  • Most auto loans are fixed. Credit card debt typically carries an adjustable-rate, while a mortgage can be fixed or adjustable.

Rising rates are good for savers, not so good for investors

We all know that when interest rates are higher, our savings increase. But they are not good for investors.

  • Rising interest rates can boost the interest you earn on a money market deposit account or a passbook savings account.

  • However, rising interest rates are generally bad news for stocks and bonds.

  • Higher rates represent increased interest costs for many companies. The reason is that usually higher rates are a response to inflation which should be under reasonable control. This higher rate is a signal to the corporations that they are encountering other cost increases as well.

  • Bond prices generally move in the opposite direction of interest rates. It is easy to see why bonds react so badly to rising interest rates. When bond matures, the institutions have to pay more to the lender – the consumers. But generally, rising interest rates will have less impact on bonds with shorter maturity and higher interest rates.

 

In a Nutshell
We all depend on the interest rate whether we like it or not, but that’s the way the modern economy and finances work. Like I said, interest is like fire. You can use it to your own advantage for a better livelihood, or it can surely ruin lives, like it has for so many people, the last year or two.

The discount rate plays a vital part in the economy at all levels. Big businesses, small businesses, individuals and families, one way or another, get affected by it. Unfortunately, some more than others. This juggling and trapeze kind of action has been going on for ages. Like I said previously, I am an immigrant and that’s what I have seen over three decades.

What goes up must come down and, fortunately for all of us, the reverse has been true as well and repeatedly I might add. So let’s hope we get out of this mess and let the responsible folks in the authority position add some hooks and nooks in the economy that next time the adverse effect is not so overwhelming on businesses, big and small, and especially on the general populace, on us folks.

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