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Interested in Interest rates?

Interest

Interest is what you earn when you let people borrow your money. Some call it the price of renting your money. Obviously how much you will rent it (ie charge) for will depend on many things. We will focus on those things in a few lessons.

The basic idea of interest is that the riskier a loan is the more you will charge. We will focus on two main risks: default risk (the risk you won’t get repaid) and inflation risk (the risk you will be repaid with money that is not worth as much as that which you lent).

Generally speaking, the more debt you already have, the lower your credit ratings, and the more volatile your earnings are, the higher the default risk and hence the higher the rates that lenders will charge.

Inflation risk is more of a macro risk factor and depends on what the market expects inflation to be over the life of your loan. The higher this expectation, the higher the rate that will be charged. This was summarized by Irving Fischer in his famous Fisher Hypothesis which (at least when interest rates are relatively low) can be summarized as the nominal interest rate = the real interest rate + expected inflation.

Other things go into the determination of interest rates (regulation, liquidity, taxes, etc) but the big two remain inflation risk and default risk.


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