LENDING INTEREST RATE: WHAT IT CONSISTS OF, FACTORS AND EXAMPLES - ECONOMY - 2024

The lending rate is the amount of interest charged per period, expressed as a percentage of the principal amount, which was paid by a lender to a borrower for the use of an asset.

Lending interest rates are generally recorded annually, known as the annual interest rate. Other interest rates may apply for different periods, such as a month or a day, but are generally annualized.

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Assets borrowed could include cash, consumer goods, and large assets, such as a vehicle or building.

The money to be paid is generally greater than the amount borrowed. This is because lenders want to be compensated for their inability to use that money during the period in which they lent those funds.

The total interest on the amount borrowed depends on the principal amount, the lending rate, the frequency of compounding, and the length of time the loan lasts.

What is the active interest rate?

Interest is essentially a rent or a lease charge to the borrower for the use of an asset. In the case of a large asset, such as a vehicle or building, the lending rate is sometimes known as the lease rate.

When the borrower is a low risk party, they will generally be charged a low interest rate. If the borrower is considered high risk, the interest rate charged will be higher.

In terms of the money that is borrowed, the lending rate is commonly applied to principal, which is the amount of money borrowed. The lending rate is the cost of debt to the borrower and is the rate of return to the lender.

These interest rates apply in numerous situations involving loans. People borrow money to buy homes, finance projects, start businesses, pay for college tuition, etc.

Businesses obtain loans to finance capital projects and expand their operations. They do this by purchasing fixed assets such as land, buildings, machinery, trucks, etc.

Cost of debt

While lending rates represent interest income to the lender, they constitute a cost of debt to the individual or business.

Businesses weigh the cost of the loan against the cost of equity (dividend payments) to determine which source of financing will be the least expensive.

Since most companies finance their capital, either through debt and / or equity issuance, the cost of equity is evaluated to achieve an optimal capital structure.

Importance

Lending interest rates are one of the strongest influences on the economy. They facilitate capital formation and have a profound effect on everything from individual investment decisions to job creation, monetary policy, and corporate profits.

In a free market economy, the laws of supply and demand generally set lending rates.

The demand for loans is inversely related to lending rates. This means that high interest rates discourage businesses and individuals, usually from undertaking capital expenditure projects. Low interest rates encourage borrowing.

However, the demand for funds is also derived from the productivity of the investments made with the borrowed capital.

For example, Company XYZ might be willing to pay a higher lending rate as long as the return on investment exceeds the cost of funds.

The loan only occurs when another person or company agrees to give up current consumption and lend the money to the borrower. However, the lending rate must be high enough to convince these lenders to lend.

For this reason, the supply of funds that can be loaned increases when lending rates rise.

Interest rates affect the prices of many investments, especially stocks. This happens because they are key components of present value and future value calculations.

This is one reason why stock prices generally rise when lending rates fall, and vice versa.

Lending rate factors

The lending rate charged by banks is determined by a number of factors, including the state of the economy. The lending interest rate in the economy is set by the country's central bank.

High lending rate

When the central bank sets lending rates high, the cost of debt rises. This discourages people from borrowing and reduces consumer demand.

In an economy with a high lending rate, people resort to saving their money, since they receive more for the savings rate.

Also, lending rates tend to rise when inflation increases. Likewise, when higher reserve requirements are established for banks, there is a restricted supply of money, or there is a greater demand for credit.

The stock market is also affected. This happens because investors prefer a higher savings rate than low stock market returns.

Companies also have limited access to equity financing through debt. This leads to a contraction in the economy.

Low lending rate

During periods of low lending rates, the economy is stimulated. This is because borrowers have access to affordable loans.

Since interest rates on savings are low, businesses and individuals are more likely to spend more and buy riskier investment avenues, such as stocks.

This supports spending in the economy and in capital markets, leading to an expansion of the economy.

Examples

Suppose an individual obtains a one-year mortgage of $ 300,000 from the bank. The loan agreement stipulates that the active interest rate on the loan is 15%.

This means that the borrower will have to pay the bank the original amount of the loan plus the interest.

This would be: $ 300,000 + (15% x $ 300,000) = $ 300,000 + $ 45,000 = $ 345,000.

If a company obtains a one-year loan of $ 1.5 million from a lending institution that charges 12% interest, the company must repay the principal amount: $ 1.5 million + (12% x $ 1.5 million) = $ 1.5 million + $ 180,000 = $ 1.68 million.

References

1. Julia Kagen (2017). Interest Rate. Investopedia. Taken from: investopedia.com.
2. Wikipedia, the free encyclopedia (2019). Interest Rate. Taken from: en.wikipedia.org.
3. Kimberly Amadeo (2018). Interest Rates and How They Work. The Balance. Taken from: thebalance.com.
4. Equifax (2018). Interest Rate Types. Taken from: equifax.co.uk.
5. Money Smart (2018). Interest Rates. Taken from: moneysmart.gov.au.