What is interest, and what are interest rates?
Nearly all of us will have encountered terms with “interest” in their names on numerous occasions, be it at a bank, a car dealership or an electronics store. But what are interest rates exactly, and what do the various terms containing the word “interest” mean? We're going to take a detailed look at the most important types of interest.
Interest is the price charged for borrowing money. The level of interest depends on the agreed interest rate. This interest rate is usually represented by a percentage figure, with “percent” meaning “per one hundred” and it determines the level of interest calculated on the amount deposited or borrowed.
Let’s now turn to the matter of specific interest rate terms, starting with the deposit rate: People save money in their bank accounts and banks can pay interest to account holders on the deposited money.
The rate of interest applied depends on the general interest rate level as well as on the size of the deposit. In addition, it is generally the case that: the longer savers forgo access to their money, the higher the interest rate will be.
Now let's suppose you wish to buy something that costs more than you actually have at your disposal. In such cases you can borrow money, for example through a bank loan.
To this end, the borrower, has to pay the bank interest on the loan. The level of the lending rate, as this interest rate is known, will depend, among other things, on the creditworthiness of the borrower. The higher the risk for the bank in terms of the borrower potentially defaulting on the loan, the higher the interest rate will be. The level of the interest rate levied also depends on the term of the loan. The longer the bank provides the money, the higher the interest rate.
Some costs attached to a loan are, however, not immediately recognisable. For instance, it may be the case that the actual amount paid out to the borrower is less than the specified loan amount. Moreover, the borrower may be charged an additional fee on top of the loan amount. The effective annual interest rate, as it is known, encompasses all the costs attached to a given loan. Banks, as well as car dealerships or electronics stores are all obliged to state the effective annual interest rate charged on a purchase so that the consumer can compare rates among different providers.
But there’s another type of interest rate besides the ones already mentioned here, and this interest rate has a huge impact on all the other rates: The key interest rate - also known as the key rate, or policy rate. When banks are in need of funds, they have to borrow from the central bank as the bank of last resort and they have to pay interest on this borrowed money. The level of interest charged as a percentage of the amount borrowed is referred to as the key interest rate. In the euro area, it is set by the Governing Council of the European Central Bank. Its level is always set with a view to remaining the purchasing power of the euro stable.
The key rate has an impact on all other interest rates in an economy and therefore also has an effect on all economic activities. When the central bank raises the key rate, commercial banks respond by raising the interest rates for their customers. This pushes up the cost of loans for customers and makes saving more rewarding. As a result, the level of demand in the economy tends to go down, thus dampening inflation. Conversely, falling interest rates lead to an increased appetite for credit and reduce the incentive to save. The level of demand in the economy thus increases, which tends to make prices go up faster.
The development of prices is measured by the inflation rate. This is important in connection with two other interest rate concepts, the nominal and the real interest rate. The stated interest rates are referred to as nominal interest rates. If the inflation rate is deducted from these, they are referred to as real interest rates.
It follows that not all interest is the same. Savers welcome high interest rates, while borrowers are glad about low lending rates.
And everyone, be it banks, enterprises, consumers or the government, observes the policy rate as an important signal for the economy.