Interest rates meaning is the financial incentive for a lender to lend money. This means that the borrower would have to pay the money lent plus the interest back to the lender. For example, if A borrows money from B, B might give a 5% interest. What that means is that A will need to pay back the original $10,000 (the principal) plus 5% of that sum by the end of the period. Her total repayment to B is, therefore, $10,500. This 5% interest may be a simple interest rate, in which subsequent years incur 5% of the principal, or a compounded interest rate, in which the 5% compounds after every year.
Why are interest rates important?
Commercial banks don’t have much flexibility when it comes to setting the interest rates – that’s up to the central banks. Think of the US Federal Reserve, the People’s Bank of China, or the Bank of England. Their job is to tinker with the economy to keep it healthy. One function they perform to these ends is raising or lowering interest rates.
If interest rates are high, then you’ll receive more interest for loaning your money. On the flip side, it’ll be more expensive for you to borrow, since you’ll owe more. Conversely, it isn’t very profitable to lend when interest rates are low, but it becomes attractive to borrow.
Ultimately, these measures control the behaviour of consumers. Lowering interest rates is generally done to stimulate spending in times when it has slowed, as it encourages individuals and businesses to borrow. Then, with more credit available, they’ll hopefully go and spend it.
Negative interest rates do exist. As you can imagine, these are sub-zero rates that require you to pay to lend money, or even to store it at a bank. By extension, it makes it costly for banks to lend. This is perhaps why negative interest rates are somETHing of a last resort to fix struggling economies. The idea comes from a fear that individuals may prefer to hold onto their money during an economic downturn, preferring to wait until it recovers to engage in any economic activity.
In Conclusion
Interest rates meaning is the financial incentive for a lender to lend money. Although they may seem like a really easy concept to grasp, they are extremely important in modern economies.
