Interest rates influence almost all financial decisions

April 15, 2005

The interest rate contributes directly to the 'rate of return'of the security, which is essentially the rate that an investor expects to receive.

The interest rate is sometimes described as the "price of money." It is the premium that must be paid to enjoy the benefits of immediate access to money.

Another way of viewing this is that the interest rate is the "opportunity cost" of money. Monetary consumption means sacrifice of the return that could be earned through investment. From this perspective, the old laser in your storeroom may be costing your practice more than you think. The opportunity cost (i.e., the interest that the monetary value of the laser could be accumulating if optimally invested) is probably considerable. This cost is in addition to maintenance costs, insurance costs, and other costs.

Key determinants of these major interest rates are the supply and demand for loanable funds or credit. Basic economic theory states that the price of money or credit (i.e., the interest rate) will decrease if supply rises. The interest rate will increase if demand rises.

Money infused into the national economy through personal and commercial bank account deposits increases the supply of credit. The demand for credit is increased through increased borrowing or through use of credit cards.

Another important factor affecting interest rates is expectation of inflation. An expectation that inflation will be high has the effect of driving interest rates up. This is because lenders fear they will be repaid with dollars of lower value. Thus, interest rates move relatively higher to compensate for the concern about repayment with money of diminished worth.

It is clear that interest rates vary greatly, depending on the type of loan being made. Some generalities regarding this phenomenon may be provided.

The interest rate offered to a reliable borrower is lower than that offered a questionable borrower because of risk. The lender must factor in a risk premium to compensate for the higher chance that the loan will not be repaid by the questionable borrower.

Pledge of collateral mitigates the risk to the lender. Therefore the borrower should expect, all other factors being equal, a lower interest rate when collateral is offered.

The duration of the loan obligation will also have an impact on the interest rate. This point is well known to anyone who has taken out a mortgage. It is interesting to consider the principles underlying this relationship between duration and interest rate, known as the "term structure of interest rates."

The term structure of interest rates is generally discussed in the context of U.S. Treasury Securities, such as Treasury bills and notes. In general, a positive correlation exists between the duration of the debt security and the interest rate. The interest rate contributes directly to the "rate of return" of the security, which is essentially the rate that an investor in the security expects to receive.

The role of inflationary expectations on the interest rate has already been mentioned. Inflationary expectations also contribute to the term structure of interest rates. This is because lenders who loan money over a long duration are exposed to inflation risk for a greater period than those who loan money over the short term. Therefore, the long-term lender will typically demand a higher interest rate than will a short-term lender.