Money Tips Network

Having understood the difference between simple and compound interest and the importance of yields, we can now look at the factors that determine an interest rate. In fact, it is more correct to talk of interest rates. At any one time a host of different rates are charged throughout the economy. So it is important to distinguish the determinants of specific interest rates are well as those which affect the general level of rates in the economy.

First, let us look at the determinants of specific rates. One of the principal elements is risk. There is always the chance, whomever money is lent to, that it will not be repaid. That risk will be reflected in a higher interest rate. This is one of the general principles of finance. The riskier the investment, the higher the return demanded by the investor. It is a principle which can be ignored, mainly because investors do not always assess risk adequately. Nevertheless, it is a useful principle to bear in mind, especially when it is stood on its head. Those investors who seek extremely high returns would be wise to remember that such investments normally involve extremely high risk.

Governments are usually presumed to be the least risky debtors of all, at least by lenders in their own country. (Other countries’ governments are a different matter, as many banks who lent to Brazil and Argentina have discovered.) But the government of a lender’s country can always print more money to repay the debt if necessary. In any case, if the government does not repay debt, it is reasonable for investors to presume that no one else in the country will.

Banks and building societies have traditionally been rated next on the credit ladder. Nowadays, however, as we noted in Chapter 2, because of banks’ exposure to the international debt crisis, many large corporations are considered better credit risks than even the biggest banks. For the benefit of potential investors, some agencies have devised elaborate rating systems to assess the credit worthiness of banks and corporations.

At the bottom of the ratings come individuals like you and me. Individuals have a sad tendency to lose jobs, get sick, over-commit themselves and default on their loans. Unless they are exceptionally wealthy, individuals thus pay the highest interest rates of all.

One of the other main elements involved is liquidity. The house buyer with a mortgage has to pay a higher rate than is received by the building society depositor because the society needs to be compensated for the loss of liquidity involved in tying up its money for twenty-five years. The society faces the risk that it will at some point need the funds that it has lent to the house buyer but will be unable to gain access to them. As I mentioned in the introduction, this is another of the basic principles of finance. The more liquid the asset, the lower the return. The most liquid asset of all, cash, bears no interest at all.

Logical though the above arguments are, it often happens that long-term interest rates are below short-term rates. To understand why, we must look at the yield curve.