Interest rate is the cost incurred on borrowing money. Regarding interest rate, many questions arises, such as why the need of interest rate? How and who determines the interest rate to be imposed on a particular loan. The article will try to answer these questions briefly.
Why Is There A Need For Interest Rates
Interest rates are very important for lenders, as when they give out loan they also have to bear some kind of risk, especially if the loan is against some kind of asset. Monetary value and assets always have a variable rate and through the passage of time its value increases and by the time borrowers pay back the money to the lender the purchasing power of that asset may have decreased.
To avoid such situations, lenders charge an amount of fee, which we know as the interest rate.
When it comes to borrowers taking a loan, for them too it is a high risk factor. Usually money is borrowed to be spent on something urgent that could prove to be beneficial to the borrower.
And for that benefit which could amount much higher than the original loan money borrowed has to be paid for in the face of interest rate. In terms of business, interest rate is the cost for money borrowed, the rate of which changes from time to time and it is the income of lending money.
How Interest Rates Are Determined
Interest rates change as the curve of supply and demand changes. When there is an increase in demand for credit(to buy more luxury items) and mortgages (to buy more homes) then the interest rate will increase, and when there is a decrease in demand so is there a decrease in the rates. But when there is an increase supply of credit, then the interest rates drop, since banks can give more money to debtors, they reduce the interest rates. Not only supply and demand affect interest rates, even inflation does so too. When a nation is experiencing inflation, people tend to need more money and since banks are short on investors (who are themselves short of cash) they raise the amount of interest rates.
Who Determines Interest Rates
The government of a state determines its monetary value and the interest rates that should be charged from customers. The U.S Federal Reserve is responsible for setting interest rates and the Fannie Mae and Freddie Mac too are ones responsible for setting mortgage interest rates.