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Interest is the rent paid on borrowed money. The lender receives rent / compensation for foregoing other uses of their funds, including (for example) deferring their own consumption. The original amount lent is called the "principal," and the percentage of the principal which is paid/payable over a period of time is the "interest rate." or "rent" collected on the money. Image File history File links Information_icon. ...
Economics offers various definitions for money, though it is now commonly defined as any good or token that functions as a medium of exchange that is socially and legally accepted in payment for goods and services and in settlement of debts. ...
In economics, consumption refers to the final use of goods and services to provide utility. ...
Types of interest
Simple interest Simple interest: simple interest does not take compounding into account, and is determined by multiplying the principal by the interest rate (per period) by the number of time periods.
To calculate: Add up all the interest paid/payable in a period. Divide that by the principal at the beginning of the period. E.g. on $100 (principal):
- credit card debt where $1/day is charged. 1/100 = 1%/day.
- corporate bond where $3 is due after six months, and another $3 is due at year end. (3+3)/100 = 6%/year.
- certificate of deposit (GIC) where $6 is paid at year end. 6/100 = 6%/year.
There are three problems with simple interest. A Guaranteed Investment Certificate is a Canadian investment that offers a guaranteed rate of return over a fixed period of time, most commonly issued by trust companies or banks. ...
- The time periods used for measurement can be different, making comparisons wrong. You cannot say the 1%/day credit card interest is 'equal' to a 365%/year GIC.
- The time value of money means that $3 paid every six months hurts more than $6 paid only at year end. So you cannot 'equate' the 6% bond to the 6% GIC.
- When interest is due, but not paid, it must be clear what happens. Does it remain 'interest payable', like the bond's $3 payment after six months? Or does it get added to the original principal, like the 1%/day on the credit card? Each time it is added to the principal it 'compounds'. The interest from that time forward is calculated on that (now larger) principal. The more frequent the compounding, the faster the principal grows, and the greater the interest amount is.
The time value of money (TVM) is a way of calculating the value of a sum of money, at any time in the present or future. ...
Compound interest Compound interest: In order to solve these three problems, there is a convention in economics that interest rates will be disclosed as if the term is one year and the compounding is yearly, otherwise known as the effective interest rate. The discussion at compound interest shows how to convert to and from the different measures of interest. Interest rates in lending are often quoted as nominal interest rates (compounding interest uncorrected for the frequency of compounding. Loans often include various non-interest charges and fees (such as points on a mortgage loan in the United States; many jurisdictions require lenders to provide information on the 'true' cost of finance, often expressed as an annual percentage rate, which expresses the total cost of a loan as an interest rate after including the additional fees and expenses (the details, however, vary). In economics, continuous compounding is often used due to specific mathematical properties. In contrast to a nominal interest rate, the period of time after that the interest is credited coincides with the basic time unit (normally one year). ...
Compound interest, is interest which is added to the original principal. ...
A loan is a type of debt. ...
A nominal interest rate is the interest rate as stated - that is, not adjusted for compounding. ...
The word point can refer to: a location in physical space a unit of angular measurement; see navigation point is a typographic unit of measure in typography equal inch or sometimes approximated as inch; on computer displays it should be equal to point in typography if the correct display resolution...
Mortgage loan is the generic term for a loan secured by a mortgage on real property; the mortgage refers to the legal security, but the terms are often used interchangeably to refer to the mortgage loan. ...
Annual Percentage Rate (APR) is an expression of the effective interest rate that will be paid on a loan, taking into account one-time fees and standardizing the way the rate is expressed. ...
Compound interest, is interest which is added to the original principal. ...
Fixed and floating rates Loans may not always have a single interest rate over the life of the loan (although they generally still use compound interest). Loans for which the interest rate does not change are referred to as fixed rate loans. Loans may also have a changeable rate over the life of the loan based on some reference rate (such as LIBOR), usually plus (or minus) a fixed margin. These are known as floating rate, variable rate or adjustable rate loans. Combinations of fixed-rate and floating-rate loans are possible and frequently used. Less frequently, loans may have different interest rates applied over the life of the loan, where the changes to the interest rate are not tied to an underlying interest rate (for example, a loan may have a rate of 5% in the first year, 6% in the second, and 7% in the third). A fixed interest rate loan is a loan where the interest rate doesnt not fluctuate over the life of the loan. ...
A reference rate is any publicly available quoted number or value that is used by the parties to a financial contract. ...
LIBOR stands for the London Interbank Offered Rate and is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale (or interbank) money market. ...
Real interest Real interest: This is approximated as (nominal interest rate) - (inflation). It attempts to measure the value of the interest in units of stable purchasing power. See the discussion at real interest rate. A nominal interest rate is the interest rate as stated - that is, not adjusted for compounding. ...
The real interest rate is the interest rate charged to a risk free borrower, minus the inflation rate. ...
Cumulative interest or return Cumulative interest/return: This calculation is (FV/PV)-1. It ignores the 'per year' convention and assumes compounding at every payment date. It is usually used to compare two long term opportunities. Since the difference in rates gets magnified by time, so the speaker's point is more clearly made.
Other conventions and uses Other exceptions: - US and Canadian T-Bills (short term Government debt) have a different convention. Their interest is calculated as (100-P)/P where 'P' is the price paid. Instead of normalizing it to a year, the interest is prorated by the number of days 't': (365/t)*100. (See also: Day count convention). The total calculation is ((100-P)/P)*((365/t)*100)
- Corporate Bonds are most frequently payable twice yearly. The amount of interest paid is the simple interest disclosed divided by two (multiplied by the face value of debt).
Rule of 78: Some consumer loans calculate interest by the "Rule of 78" or "Sum of digits" method. Seventy-eight is the sum of the numbers 1 through 12, inclusive. The practice enabled quick calculations of interest in the pre-computer days. In a loan with interest calculated per the Rule of 78, the total interest over the life of the loan is calculated as either simple or compound interest and amounts to the same as either of the above methods. Payments remain constant over the life of the loan; however, payments are allocated to interest in progressively smaller amounts. In a one-year loan, in the first month, 12/78 of all interest owed over the life of the loan is due; in the second month, 11/78; progressing to the twelfth month where only 1/78 of all interest is due. The practical effect of the Rule of 78 is to make early pay-offs of term loans more expensive. Approximately 3/4 of all interest due on a one year loan is collected by the sixth month, and pay-off of the principal then will cause the effective interest rate to be much higher than than the APY used to calculate the payments. [1] In finance, a day count convention is a method to calculate the fraction of a year between two dates. ...
The United States outlawed the use of "Rule of 78" interest in loans over five years in term. Certain other jurisdictions have outlawed application of the Rule of 78 in certain types of loans, particularly consumer loans. [2]
Rule of 72: The "Rule of 72" is a "quick and dirty" method for finding out how fast money doubles for a given interest rate. For example, if you have an interest rate of 6%, it will take 72/6 or 12 years for your money to double, compounding at 6%. This is an approximation that starts to break down above 10%. In finance, the rule of 72, the rule of 70 and the rule of 69. ...
Market interest rates There are markets for investments which include the money market, bond market, as well as retail financial institutions like banks, which set interest rates. Each specific debt takes into account the following factors in determining its interest rate:
Opportunity cost: This encompasses any other use to which the money could be put, including lending to others, investing elsewhere, holding cash (for safety, for example), and simply spending the funds. In economics, opportunity cost, or economic cost, is the cost of something in terms of an opportunity forgone (and the benefits that could be received from that opportunity), or the most valuable forgone alternative (or highest-valued option forgone), i. ...
Inflation: Since the lender is deferring his consumption, he will at a bare minimum, want to recover enough to pay the increased cost of goods due to inflation. Because future inflation is unknown, there are three tactics.
- Charge X% interest 'plus inflation'. Many governments issue 'real-return' or 'inflation indexed' bonds. The principal amount and the interest payments are continually increased by the rate of inflations. See the discussion at real interest rate.
- Decide on the 'expected' inflation rate. This still leaves both parties exposed to the risk of 'unexpected' inflation.
- Allow the interest rate to be periodically changed. While a 'fixed interest rate' remains the same throughout the life of the debt, 'variable' or 'floating' rates can be reset. There are derivative products that allow for hedging and swaps between the two.
Default: There is always the risk the borrower will become bankrupt, abscond or otherwise default on the loan. The risk premium attempts to measure the integrity of the borrower, the risk of his enterprise succeeding and the security of any collateral pledged. For example, loans to developing countries have higher risk premiums than those to the US government due to the difference in creditworthiness. An operating line of credit to a business will have a higher rate than a mortgage. The real interest rate is the interest rate charged to a risk free borrower, minus the inflation rate. ...
Creditworthiness of businesses is measured by bond rating services and individual's credit scores by credit bureaus. The risks of an individual debt may have a large standard deviation of possibilities. The lender may want to cover his maximum risk. But lenders with portfolios of debt can lower the risk premium to cover just the most probable outcome.
Deferred consumption: Charging interest equal only to inflation will leave the lender with the same purchasing power, but he would prefer his own consumption NOW rather than later. There will be an interest premium of the delay. See the discussion at time value of money. He may not want to consume, but instead would invest in another product. The possible return he could realize in competing investments will determine what interest he charges. The time value of money (TVM) is a way of calculating the value of a sum of money, at any time in the present or future. ...
Length of time: Time has two effects.
- Shorter terms have less risk of default and inflation because the near future is easier to predict than events 20 year off.
- Longer terms allow for investments in larger projects with higher eventual returns. Contrast this to the lender's preference for readily available cash for contingencies. This is why banks pay higher interest on non-redeemable GICs than on chequing account balances.
- Long-term interest rates fell in much of the developed world in the second half of 2006.
Other: Borrowers and lenders may face individual tax rates, transaction costs and foreign exchange rate risks. In a liquid market they cannot exert their personal preferences. It is the sum total of the participants who determine rates. The market for financial instruments has moved from the local, to the national, and is now international. For the Manfred Mann album, see 2006 (album). ...
Interest rates in macroeconomics
Output and unemployment Interest rates are the main determinant of investment on a macroeconomic scale. Broadly speaking, if interest rates increase, then investment decreases due to the higher cost of borrowing (all else being equal). Invest redirects here. ...
Interest rates are generally determined by the market, but government intervention - usually by a central bank- may strongly influence short-term interest rates, and is used as the main tool of monetary policy. The central bank offers to buy or sell money at the desired rate and, due to their control of certain tools (such as, in many countries, the ability to print money) they are able to influence overall market interest rates. Monetary policy is the process by which the government, central bank, or monetary authority manages the money supply to achieve specific goals—such as constraining inflation or deflation, maintaining an exchange rate, achieving full employment or economic growth. ...
Investment can change rapidly to changes in interest rates, affecting national income, and, through Okun's Law, changes in output affect unemployment. In economics, Okuns Law, named after economist Arthur Okun, describes a relationship between the change in the rate of unemployment and the difference between actual and potential real GDP. In the United States during the period since 1965 or so, Okuns Law can be stated as saying that...
An 1837 political cartoon about unemployment in the United States. ...
Open Market Operations in the United States
The effective federal funds rate charted over fifty years The Federal Reserve (often referred to as 'The Fed') implements monetary policy largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed. Description: Historical chart of the U.S. federal funds rate. ...
Description: Historical chart of the U.S. federal funds rate. ...
Monetary policy is the process by which the government, central bank, or monetary authority manages the money supply to achieve specific goals—such as constraining inflation or deflation, maintaining an exchange rate, achieving full employment or economic growth. ...
The federal funds rate is the interest rate at which depository institutions lend balances (federal funds) at the Federal Reserve to other depository institutions overnight. ...
Federal Funds transactions redistribute bank reserves. ...
Open market operations are one tool within monetary policy implemented by the Federal Reserve to steer short-term interest rates. Using the power to buy and sell treasury securities, the Open Market Desk at the Federal Reserve Bank of New York can supply the market with dollars by purchasing T-notes, hence increasing the nation's money supply. By increasing the money supply or Aggregate Supply of Funding (ASF), interest rates will fall due to the excess of dollars banks will end up with in their reserves. Excess reserves may be lent in the Fed funds market to other banks, thus driving down rates. Open Market Operations are the means by which central banks control the liquidity of the national currency. ...
Securities are tradeable interests representing financial value. ...
The Federal Reserve Bank of New York, located at 33 Liberty Street in Manhattan. ...
Federal Funds transactions redistribute bank reserves. ...
Money and inflation Loans, bonds, and shares have some of the characteristics of money and are included in the broad money supply. Economics offers various definitions for money, though it is now commonly defined as any good or token that functions as a medium of exchange that is socially and legally accepted in payment for goods and services and in settlement of debts. ...
By setting i*n, the government institution can affect the markets to alter the total of loans, bonds and shares issued. Generally speaking, a higher real interest rate reduces the broad money supply.
Through the quantity theory of money, increases in the money supply lead to inflation. This means that interest rates can affect inflation in the future. In economics, the velocity of money refers to a key term in the quantity theory of money, which centers on the equation of exchange: where is the total amount of money in circulation in an economy at any one time (say, on average during a month). ...
History The collection of interest was restricted by Jewish, Christian, Islam and other religions under laws of usury. This is still the case with Islam, which mandates no-interest Islamic finance.[3] Of Usury, from Brants Stultifera Navis (the Ship of Fools); woodcut attributed to Albrecht Dürer Usury (//, from the Medieval Latin usuria, interest or excessive interest, from Latin usura interest) was defined originally as charging a fee for the use of money. ...
Islam (Arabic: ) is a monotheistic religion based upon the teachings of Muhammad, a 7th century Arab religious and political figure. ...
Islamic Finance is based on interpretations from the Quran. ...
Irving Fisher is largely responsible for shaping the modern concept of interest with his 1930 work, The Theory of Interest. Irving Fisher (February 27, 1867 Saugerties, New York — April 29, 1947, New York) was an American economist, health campaigner, and eugenicist. ...
See also Look up interest in Wiktionary, the free dictionary. Wikipedia does not have an article with this exact name. ...
It has been suggested that French Wiktionary be merged into this article or section. ...
In economics the rate of return on investment refers to the benefits to an investor (the profit) relative to the cost of the initial investment. ...
A credit rating agency, credit reporting agency (CRA), or credit bureau (US), or credit reference agency (UK) is a company that assigns credit ratings for corporations and individuals. ...
Credit card interest is the principal way in which card issuers generate revenue. ...
NOTE: this is not Fishers equation in differential equations The Fisher equation in financial mathematics and economics estimates the relationship between nominal and real interest rates under inflation. ...
Mortgage loan is the generic term for a loan secured by a mortgage on real property; the mortgage refers to the legal security, but the terms are often used interchangeably to refer to the mortgage loan. ...
The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no risk. ...
The US dollar yield curve as of 9 February 2005. ...
The time value of money (TVM) is a way of calculating the value of a sum of money, at any time in the present or future. ...
Of Usury, from Brants Stultifera Navis (the Ship of Fools); woodcut attributed to Albrecht Dürer Usury (//, from the Medieval Latin usuria, interest or excessive interest, from Latin usura interest) was defined originally as charging a fee for the use of money. ...
Monetary policy is the process by which the government, central bank, or monetary authority manages the money supply to achieve specific goals—such as constraining inflation or deflation, maintaining an exchange rate, achieving full employment or economic growth. ...
The cash accumulation equation is an equation which calculates how much money will be in a bank account, at any point in time. ...
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