Interest Rate

What It Means

The term “interest rate” is used when discussing credit cards, car and home loans, and other forms of borrowing of money. Represented as a percentage, it refers to the fee the bank, credit card company, or other institution charges to lend money. For example, if you buy an MP3 player for $100 with a credit card, the credit card company pays the bill—in other words, it lends you $100—and charges you interest, or a fee, for that loan.

This fee, known as the interest rate, is a percentage of the amount borrowed. In the example of the MP3 player, the credit card company might charge an interest rate of 15 percent per year. If you paid the bill immediately, you would owe no interest. If you waited a year to pay the bill, you would be charged 15 percent of the $100 loan, or $15, raising the total amount owed to $115.

Charging interest is how banks and other lending institutions make money, and without it they would have no incentive to make loans. Lending money, in turn, is essential for the economy. It allows people to make necessary large purchases, such as cars and homes; to pay for college tuition; and to afford vacations and other desired nonessential purchases. Companies borrow money for a variety of reasons, such as buying manufacturing equipment, that help them start up, grow, and compete with other businesses. Even governments take out loans when they spend more money than they raise with taxes.

Consumers, businesses, and governments all pay an interest rate on their loans. Their desire or even ability to take out a loan will often be determined by the size of the interest rate. If an interest rate is low, such as 5 percent, a loan is much cheaper and much more desirable than if it were 20 percent. For example, when buying a house with a 30-year loan, a person might spend hundreds of thousands of dollars more on interest (over the 30-year period) if the rate were 20 percent as opposed to 5 percent.

Modern economies are greatly influenced by changes in interest rates. Generally speaking, when interest rates fall, three things happen: more loans are made, money from the loans (otherwise not available to people, businesses, and governments) is spent, and thus the economy grows more quickly. When interest rates rise, the reverse happens, and economic growth slows down.

When Did It Begin

The use of interest began thousands of years ago, even before the invention of money. In ancient Mesopotamia (a region in southwestern Asia) people would acquire what they needed through trading (for example, tools for cloth). Loans were often made in silver for large transactions and in grain for smaller ones. Charging interest on these loans met with intense criticism in the ancient world: philosophers and spiritual figures as diverse as Plato, Moses, Buddha, Jesus, and Mohammed condemned the phenomenon as immoral, and prohibitions on “usury,” a negative term for the collection of interest, remained widespread as late as the Middle Ages.

In time interest on loans came to be seen as a necessary part of doing business in much of the world, and usury took on a new definition: the charging of exploitative or very high rates of interest. By the Enlightenment (a philosophical movement in the 1700s that emphasized the use of reason over religious and traditional perspectives), economic thinkers focused less on interest collection as a moral issue and increasingly on how interest rates affected the economy.

A notable exception to this historical trend was in the Islamic world, where some Muslims viewed interest as a form of gambling and a violation of their sacred text, the Koran. Interest, in fact, remains a controversial issue in Islamic countries, and a specialized banking system, called Islamic banking, was developed in the late twentieth century to avoid the religious prohibition on interest. Instead of lending money, a bank would buy the home, car, or other item for the consumer and resell it to the consumer, in installments, at a higher price.

More Detailed Information

There are various ways interest rates are understood. In its simplest form, an interest rate is the percentage of the principal (as the original loan amount is commonly called) charged over a designated period of time, typically a year. In the case of the MP3 player, the interest rate is 15 percent per year.

The real interest rate takes into account the yearly inflation rate (that is, the average percentage increase in the price of all goods and services in the economy). If the average price increase, or inflation, for the year were 3 percent (thus reducing the purchasing power of your money by the same amount), the real interest rate would, in the example, be 15 percent minus 3 percent, as the $115 owed to the credit card company would be worth 3 percent less than when the purchase was made.

Another common term is compound interest. Without compound interest, a $100 loan with a 15 percent interest rate would result in the following amounts due, assuming you made no payments: $115 after the first year, $130 after the second, $145 after the third. In other words, each year the company would charge you 15 percent of the principal. Instead, banks, credit card companies, and other institutions charge compound interest. The first year would be 15 percent of the $100 loan, increasing the amount due to $115; the second year would be 15 percent of $115, boosting the loan amount to $132.25; and for the third year, the amount owed would be $152.09. Each year you would pay interest, or a percentage fee, not only on the principal but also on the interest from the previous year, thus creating “compound” interest. For credit cards, payments are due each month, and the annual interest rate (15 percent in the example) is really a compound interest of 12 monthly interest rates.

Interest rates are also used in such financial services as savings accounts and CDs. CDs, or certificates of deposits, are similar to savings accounts but do not allow any withdrawals for a designated period of time, such as one year. Consumers and businesses open savings accounts and CDs to earn interest on their deposits. If you deposit $100 in a savings account or CD that offers an interest rate of 5 percent, you will have $105 in that account after a year. In this way, consumers and businesses receive interest because they “lend” money to the bank.

Bonds, another form of borrowing money, use interest as well. In order to raise money, governments and corporations sell bonds, which are essentially certificates that promise that the government or corporation will repay the price of the bond, plus interest, after a designated amount of time, such as five years. Government bonds are often called securities. The U.S. government, for example, sells securities to pay for the national debt (when the government spends more than it collects in taxes, there is a debt, which the government must pay). Local governments commonly sell bonds to pay for large-scale projects, such as schools, swimming pools, and jails.

The exact interest rate of a loan—5.2 percent or 23.5 percent, for example—is largely determined by the market forces of supply and demand and thus is beyond the control of any individual person or institution, such as a bank. When looking for a home loan, or mortgage, a consumer can go from bank to bank to find the best price, thus encouraging banks to compete with each other in offering the lowest possible interest rates. But because interest pays for a bank’s operating costs—and because inflation (rising prices in the economy) reduces the value of money each year—there is a limit to how low an interest rate can be.

Governments, however, have significant influence over interest rates and inflation, notably through their central banks (in the United States, the Federal Reserve), which try to manipulate rates by increasing or reducing the supply of money. Other factors, such as the size of the government’s national debt, also have the potential to affect interest rates. When the national debt rises, the government pays for it by borrowing money, in some cases increasing the demand, and thus the price (or interest rate), for the limited supply of money available for loans.

Recent Trends

In the 1990s interest rates in the United States dropped significantly, and as a result, loans became much cheaper for homes, cars, and everyday purchases made with a credit card. For a 30-year home loan, or mortgage (which requires monthly payments for 30 years), the average interest rate fell from almost 10 percent in 1989 to about 5.5 percent in 2003, making it considerably easier to afford a loan. In 1989 you would need to make about $63,000 and have no outstanding debt to afford a $200,000 house using a 30-year mortgage, which required a payment of $1,764 per month. By 2003, because the lower interest rate meant a much smaller monthly payment of $1,148, the salary requirement for the same loan amount dropped to about $40,000.

For consumers, however, the result was mixed. Although it became easier to get a loan for $200,000, the average home price in the United States also rose significantly—from $79,000 in 1989 to $170,000 in 2003 to $213,000 in 2005—largely because lower interest rates allowed consumers to spend more money and because a declining stock market during the same period encouraged people to invest in homes instead, thus increasing the demand for housing. Those who benefited most were people who got their loans before the increase in home prices and who were able to get new and cheaper loans after the interest rates dropped.