Everything You Need to Know About Interest Rates
In our recent study Perceptions and Understanding of Money — 2020, we surveyed Americans to gauge how well they understand the mechanisms of money, including phenomena such as interest rates. We hope that this “Everything You Need to Know” series will help improve understanding of money-related topics and issues which could not be more relevant today.
Hopefully, this specific topic will keep you interest-ed.
What Is Interest?
The way to begin explaining interest rates is to first define interest. Interest is the amount that you are charged for borrowing money, or conversely the amount that you receive from lending money.
You may be subject to interest charges if:
- You have student loans
- You have a credit card (or 15)
- You have a mortgage
- You have a business loan
- You have a personal loan
You may also be the beneficiary of interest. You may collect interest on:
- A personal loan that you have made to a friend, family member, or colleague
- Savings that you have in a bank, as you are considered to be lending the bank the amount of your deposit
- Any bonds that you own
- Investments in money market accounts
- Funds in your retirement account(s)
From the perspective of the investor or lender, interest is good. You may view it less favorably if someone is earning interest off of your borrowed money. Either way, interest is woven into the fabric of the economy as we know it.
What Do Interest Rates Mean?
Interest rates are the percentage that you will be charged (generally on an annual basis) for borrowed money. Alternatively, it is the rate that you will be paid for lending money.
Wait, can’t I make interest simply from putting my money in the bank?
Yes, you can, but you are technically lending that money to the bank. Banks have the freedom to loan your deposit (and other customers’ deposits — you’re not being picked on) and earn interest for themselves through a process known as fractional reserve banking. This means that you are essentially lending your bank money so that they can lend it themselves, and you get interest for doing them the favor.
When discussing the rate of interest that you will receive as an investor or have to pay to a lender, you must be aware of how interest is calculated.
There are two primary ways of calculating interest:
- Simple interest
- Compound interest
When you are charged (or receive) simple interest, you pay interest on the amount of money that you initially borrowed or lent. So, if you lend $10,000 at a rate of 10% per month, you should receive $1,000 per month until the loan is paid off.
When you are charged compound interest, the rate of interest that you pay may vary from one pay period to the next, with the cost of added interest factored into your monthly (or yearly) payment. So, if you borrowed $10,000 at a 10% monthly rate, then your initial interest payment will be 10% of $10,000, or $1,000. If you do not make your interest payment, the cost of your loan will now become $11,000.
With compound interest, you will now be charged 10% of $11,000 (rather than 10% of the principal, $10,000) as interest for the following month. This means your interest payment will go up from $1,000 to $1,100. If you were paying simple interest, your interest payment would be $1,000 throughout the life of the loan.
Increase the sums being loaned or borrowed, and even the interest rate, and you have significant ramifications in terms of money being collected by a creditor or being charged to the borrower.
Interest Rates: Friend or Foe?
You may have a love or hate relationship with interest rates depending on your status as a borrower or lender, or the timing of certain investments that you have made.
If you are a net borrower, you may generally loathe interest, and compounding interest in particular. This may be especially true for those with one or more high-interest credit cards that they can never seem to pay down, student loans that seem to grow rather than shrink (despite graduation being far in your rearview mirror), or other types of high-interest debt.
If you are a lender, interest may be the additional revenue stream that you do not have to work for — handing over that initial loan was all you had to do. From Visa’s perspective, your debt is the loan that keeps on giving. But even as a lender or investor, interest rates can leave you miffed.
Imagine you buy a boatload of government or corporate bonds at a 3% interest rate, and the prevailing rate for such bonds goes up to 7% only a year later. You’re making money on interest, sure, but not nearly as much as you could have if you had locked in a rate of 7%.
Remember, at least you’re not the one paying the interest. And even if you are paying interest, keep in mind there’s always someone with more debt that you (hint: it’s your government).
Interest Rates, National Borrowing, and Cryptocurrency
Just like you, your representatives in government borrow money. They just borrow a lot more of it, so much so that the total costs of their debts (interest compounding by the millisecond, of course) is greater than $26 trillion — and that’s just America.
Say you had that level of debt on a personal scale. Your credit score would be virtually nonexistent. And yet, the dollar is based on the “full faith and credit” of a government whose run its would-be credit score through the Earth’s core long ago.
Those who see this framework as unsustainable have turned to cryptocurrency as a fresh slate. No mass-scale borrowing, no fiat currency, no unsustainable interest rates, just a peer-to-peer medium of exchange based on scarcity that once defined the U.S. dollar (but no longer does). If you’re fortunate, your Bitcoin may even compound before your eyes.
Interest-ed in owning your own coins? Start mining Bitcoin with us!