Interest rates are the rate at which a lender is prepared to charge for the use of financial services. The interest rate charged is normally expressed as a yearly percentage amount and known as the annual percentage rate or APR.
While interest rates are most commonly associated with cash-related services such as loans, credit cards, and overdrafts, they can also be applied to a variety of different asset classes. These may include goods, commodities, and large assets such as buildings.
Types of interest rates
The three main interest rates are regulated by the central banks of a country. They are the nominal interest rate, the real interest rate, and the effective rate.
Nominal interest
The nominal interest rate is the rate at which interest on repayments is calculated.
Real interest rate
The real interest rate subtracts the rate of inflation from the nominal interest rate, resulting in a more accurate view of the purchasing power of the interest being earned. This rate tends to be the rate of most interest to investors and lending parties.
Effective rate
The effective interest rate compares the annual interest rate with different compounding terms. For example, if two lenders both charged interest of 10% APR on their loan provision, but one compounded monthly, while the other compounded quarterly, this would result in different amounts of interest being paid in monetary terms. Monthly compounding results in higher values of interest than quarterly, quarterly more than semi-annually, and so on.
Who decides interest rates?
Central banks set their country’s main interest rate as part of their monetary policy to help control other economic factors such as the country’s inflation rate. This is often referred to as the base rate.
Reference rates such as wibor, Euribor, and Libor are used as a standard to set other interest rates. Libor or the London interbank offered rate is the most commonly used reference rate.
Lenders consider a wide range of factors to calculate their interest rates, these commonly include the level of interest in the market for a particular asset or facility, along with market competition, the debt to security ratio offered by the borrowing party, and the perceived risk of default on the part of the borrowing party. The latter is usually measured by a credit rating.
Key takeaways:
- Interest rates are the rate at which a lender will charge for lending to the borrowing party
- There are three main interest rate types, nominal interest, real interest rate, and effective interest rate
- Major base interest rates are set by the central bank of a country and are used as part of monetary policy to help shape the country’s economy
- Reference rates are used as a benchmark to set other interest rates