What is Interest?
In very simple terms, interest refers to the cost incurred for borrowing money. It is also known as the cost of debt. When someone borrows money, the charge they pay is the interest. On the other hand, the person who lends money earns an interest. Interest is calculated based on a specified rate. If the interest rate is high, it means that the cost of borrowing is higher and vice versa. Apart from paying interest for borrowing, one can also earn interest for lending to financial institutions. For instance, when you deposit money in the bank, you earn interest because it is viewed as lending to the bank. Ideally, the bank lends your money out to clients who want loans. Not all bank accounts pay interests. Often, banks pay interests on certificates of deposit and savings accounts to encourage people to keep more money in the bank.
What determines Interest Rates?
Access to credit increases as the more money is availed to borrowers. Interest rates therefore are determined by the demand and supply of credit; the higher the demand, the higher the interest rates. A decrease in demand for credit leads to lower interest rates. On the other hand, if the supply of credit rises, then interest rates reduce while low supply causes them to rise. The level of inflation also affects interest rates. When inflation rate is high, the cost of borrowing rises. This happens because lenders demand for higher rates in order to compensate themselves for the reducing power of money. Interest rate is also determined by the government. For instance, the Federal Reserve in the US makes regular announcement on how the monetary policy influences interest rates. The rate institutions use to charge each other on temporary loans influences the rate set by banks on loaned money.