An interest rate, usually expressed as a percentage, is an amount charged to the borrower on the principal by the lender for the usage of the lender’s assets. The rates are usually computed annually, bringing the term annual percentage rate (APR). The assets could be large assets like a building, a vehicle, cash, or consumer goods. The interest includes the amount chargeable on the rented or hired item to the mortgagor for utilizing the property. A lower interest rate is usually charged when the borrower is considered to pose a low risk and higher if he is considered to pose a higher risk.
The interest rate charged is compensation for the loss that takes place due to the use of the asset. In the case of a large asset, it would have been used to generate revenue if the owner was using it himself or herself, or in the case of cash, the owner would have invested the money and gotten returns. The rate of the simple interest is usually the same for the whole period than that, charged while compounding grows since the interest is usually charged on the sum of the principal and the interests of the previous months. For short periods of one year and below, the interests are usually similar, but as the period increases, the differences in the amounts of the interests in the two categories widen.
Impact of the interest rates on the borrowers
The categories of borrowers that can get very highly impacted by the interest rates are mortgage homeowners. A sharp rise in the interest rates will have an adverse effect on those who would also want to own homes using mortgages since they would have higher amounts to settle. Those with bank loans or planning to take bank loans would also have to settle higher amounts. A rise in the interest rates, therefore, discourages borrowing, while the opposite (a reduction in the rates) would encourage borrowing. The reduction in borrowing would mean a reduction in the investments that the borrowers would undertake using the borrowed funds.
Factors influencing the interest rates
The first factor influencing the interest rates is the cash reserve ratio usually imposed by the central bank of any country. All banking organizations are mandated to hold back a proportion of the charges with the central bank always. The percentages are usually based on the net transaction accounts of the bank. The banks, which hardly have sufficient amounts from account holders, must get temporary mortgages from different financial institutions to meet the required reserve levels. In getting the loans, the banks pay interest, and this interest is passed on to the consumers through the interest rates that the bank sets.
The second factor affecting the interest rates is the discount rate. The central bank also acts as a lender at times to the commercial banks to enable them to meet the reserve requirements that are set by the law. The costs of borrowing from the central bank are usually high, but they usually provide loans to the commercial banks at discounted rates so that they can be able to provide affordable loans to individuals and businesses. The more affordable the rates charged by the central bank, the more affordable the interest rates set by the commercial banks for the consumers.
Consideration is also given to anticipations of inflations in the future when setting interest rates for borrowing. If high rates of inflation are anticipated, the lenders would most likely charge higher rates since the money that they would get back would be less valuable. The idea of demand and supply is also a strong determinant of interest rates. In a case where there is a low request for the loans and mortgages, the charges usually decline, while a rise in the request tends to increase the amount charged on the lent money. In a market that is oversaturated with loans and mortgages, the interest rates will go down while, in a situation where the providers of the loans are few, the interest rates will rise.
The rates of interest are also determined by the expected risk of defaulting on the amounts borrowed. There are individuals who usually have a tendency or history of poor credit or late payments. Such individuals would, most likely, pose the same bad behavior towards a new loan that is acquired. It is not easy for a customer to influence the other factors that affect the interest rates but having a clean credit history will make one easily trustable by a bank and would even help one in acquiring a loan at a lower interest rate.