HOW INTEREST RATES WORK

When borrowing or investing, we are always concerned about the applicable interests. Borrowers want lower interest rates. Investors want higher interest rates. Interest rate is the cost of borrowing money or the reward for lending or saving money.

INTEREST RATES AND YOU

FIXED AND VARIABLE RATES: Financial institutions charge fixed or variable rates on loan facilities. With fixed rates, the interest rate charged remains fixed for the entire loan period. Most conventional mortgages are on fixed rates.

Variable rates, however, change according to the prime lending rates of the relevant country. Commercial banks typically add a markup to these rates and issue loans based on the marked-up rates. Loans based on variable rates may see their interest payments fluctuate throughout the life span of the loan.

SIMPLE VS COMPOUND INTEREST RATES: Loans are based on either simple or compound rate basis. When based on simple interest, the interest is computed on the principal loan amount only. When based on compound interest, the interest is computed on the principal loan amount plus the accumulated interest till date of the computation. Simple interest is favorable to the borrower while lenders and savers would prefer to receive interest on compound interest basis.

Some investments that give compound interests are:

Fixed-term deposits: This is a form of savings account where the saver would lock their money with a financial institution for a fixed period. The financial institution accrues and, in some cases, pays interest on the balance daily/monthly.

Bonds: Buying bonds, either from corporations or governments, involves giving a loan for a fixed period at a specified rate on a compounding interest basis. Upon expiration, the loan will be repaid, principal plus accrued interest. The safest type of bond is the government bond.

High Interest Saving Accounts: With high-interest savings accounts, owners earn interest on their money based on their deposits. This savings account provides higher interest rates compared to your regular savings accounts. Financial institutions like PiggyVest, Cowrywise ALAT by Wema and others offer this product. Some traditional banks offer similar products like Fidelity’s ‘High Yield Savings Account’.

Please note that we are by no means advocating for any of these platforms. Always conduct due diligence and investigations before using these or any other investment platforms.

INTEREST RATE AND THE ECONOMY

Interest rate is one of the most used tools by governments to control economic growth within their regions. In our previous article, how the economy works, we explained why the Central Bank uses interest rates. Now, let us explain how it works.https://broadstreetfinancialreview.com/2021/10/11/how-the-economy-works/

Commercial banks keep money with the Central Bank as reserves. Interest is accumulated and earned on these reserves at specified rates. This investment type is a safe one to the commercial banks hence, the banks lend to their customers at higher, less-safe, competitive rates. As the interest rate given to commercial banks by the Central Bank is the benchmark for lending rates in the economy, how does this affect the economy?

When interest rates are lowered: When the Central Bank lowers interest rates, the cost of borrowing reduces. Hence, people borrow more and spend more. This boosts economic activities, and the economy grows. If left low for an extended time, it may cause excess money in circulation. When too much money chases too few goods, inflation arises, and prices increase in the markets.

When interest rates are raised: When inflation arises and market prices are rising too fast, the Central Bank may slow this down by raising interest rates. This makes borrowing more expensive and the disposable income of individuals and corporations are reduced meaning less spending and less money in circulation. The economy’s growth rate will reduce as corporations no longer have enough money for expansion activities. Inflation also decreases as people are encouraged to spend less and save more because they can get higher interests on their savings.

We hope you have enjoyed and most importantly learnt from this article. Do have a great week ahead.

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REFERENCES

Corporate Finance Institute. (2019, November 13). Types of Interest. https://corporatefinanceinstitute.com/resources/knowledge/credit/types-of-interest/

How are Interest Rates Determined and What Affects Interest Rates. (2017, March 29). YouTube. https://www.youtube.com/watch?v=lBYt8Axmt8I

Interest Rates and How They Work. (2020, October 26). The Balance. https://www.thebalance.com/what-are-interest-rates-and-how-do-they-work-3305855

Investing for beginners UK: Interest Rates Explained. (2019, November 2). YouTube. https://www.youtube.com/watch?v=poWduPkk6Ug (2019, August 1). What Are The Best Compound Interest Investments? Top 7 Picks. Horizon Trust. https://www.horizontrust.com/what-are-the-best-compound-interest-investments-top-7-picks/

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