Economists observe that money’s value is affected by time: a dollar today is worth more than a dollar tomorrow. This has to do with opportunity cost and inflation. If you lend your friend the money in your wallet, your opportunity cost is the sacrifice of its immediate use. When your friend eventually pays you back, the money will have lost purchasing power due to inflation. For example, the chair that cost $50 when you loaned the money might cost $55 two years later when your friend pays you back, meaning not only were you unable to buy the chair when you first needed it, but it will cost you more to buy it now. There is also the risk that your friend will move to Costa Rica and “forget” to pay you back.
As a result, when people lend money, they often ask to be rewarded with an additional payment—interest—to offset the opportunity cost and inflation. When you deposit money in your savings account, you expect to earn interest for the same reason. Otherwise you would just stuff the money under your mattress.
Interest is nothing more than a payment for using money. An interest rate is the price of using money. What determines this price? It helps to think of an interest rate as a set of blocks stacked upon each other. These blocks include:
Let’s look at each of these more closely.
The first block represents the opportunity cost of using money. Some people will readily forgo the immediate use of their funds in order to receive interest. Others might be unwilling to sacrifice the immediate use of their money. In the absence of inflation or risk, the interest rate that equates the level of saving to the level of borrowing is the basic interest rate or real interest rate.
In other words, if you’re willing to forgo the opportunity to use your money for a 2% interest payment (also called a return), then that would be the basic interest rate for the money you’re lending. As you can imagine, the real interest rate varies from place to place and time to time. If most people are more interested in spending their money now than in forgoing its use to earn interest, the interest rate will have to rise to make them change their thinking.
Many older Americans can remember a time in the late 1970s and early 1980s when interest rates on loans like home mortgages were as high as 20%. Compared to today’s low rates, that is quite a difference. The explanation for the difference is inflation. Interest rates include a premium for inflation. So even though your savings is earning a much lower rate today, when you adjust for inflation, the differences pretty much disappear.
While the basic interest rate of 2% may repay you for your opportunity cost, it doesn’t account for inflation, which will eat away at that return. So, the second block of interest represents the cost of expected inflation. Assume that inflation has been stable for years at a rate of 3% and people are pretty confident that it will remain at 3%. A lender or investor will cover the cost of expected inflation and add 3% to the 2% real interest rate, to arrive at a nominal interest rate of 5%. The nominal interest rate is the basic rate that an investor or lender will charge for the use of money.
If there is a chance that the loan or investment will go bad, then it makes sense to add another block to the stack. This third block is referred to as default risk premium. The bigger the risk of default or nonpayment, the bigger the block, and the bigger the total nominal interest rate. Someone with a track record of paying back loans in a timely fashion will be considered less risky to loan money to than someone who has a spotty record of paying back loans and will thus pay a lower total interest rate.
If there is a chance that the investment or loan will be difficult to turn around and sell to another lender or investor, like a ten-year car loan, another interest block is added. This is because there’s money to be made in buying and selling loans but not so much when those loans are for non-liquid commodities. Not many people are willing to assume the risk of buying a loan that is backed by a fully depreciated asset, such as a car at the end of a ten-year loan. This fourth block is referred to as a liquidity premium. Commodities that are difficult to turn into cash demand a higher interest rate.
One final block is added for maturity risk. As time passes, there is a chance that interest rates will increase. If this happens, the value of the investment decreases, because who would want an investment that earns only 2% when you can get a similar one that earns 4%?
So, here’s an example of how an interest rate is calculated: The real interest rate is 2% and the inflation rate is 3%, which combine to form a 5% nominal interest rate. Assume the risk premium is 4%, the liquidity premium is 2%, and the maturity risk premium is 1%. The total nominal interest rate would stack up to 12% (2% + 3% + 4% + 2% + 1%).