Economics Online Tutor
INCLUDED HERE IS A BRIEF INTRODUCTION TO
INTEREST RATES. THE DISCUSSION OF INTEREST
RATES STARTS ON THIS PAGE, AND CONTINUES
ON THE PAGE ENTITLED "THE EFFECTS OF
INFLATION ON INTEREST RATES". YOU CAN JUMP
TO THAT PAGE BY CLICKING HERE. INTEREST
RATES ARE ALSO DISCUSSED AS THEY RELATE TO
OTHER TOPICS IN ECONOMICS WITHIN THE
DISCUSSION OF THOSE TOPICS.
INTEREST RATES. THE DISCUSSION OF INTEREST
RATES STARTS ON THIS PAGE, AND CONTINUES
ON THE PAGE ENTITLED "THE EFFECTS OF
INFLATION ON INTEREST RATES". YOU CAN JUMP
TO THAT PAGE BY CLICKING HERE. INTEREST
RATES ARE ALSO DISCUSSED AS THEY RELATE TO
OTHER TOPICS IN ECONOMICS WITHIN THE
DISCUSSION OF THOSE TOPICS.
| INTEREST RATES |
WHAT IS AN INTEREST RATE?
WHEN A BORROWER (DEBTOR) AND A LENDER (CREDITOR) ENTER
INTO A CONTRACT, THE BORROWER RECEIVES FUNDS AT THE
PRESENT TIME FROM THE LENDER IN EXCHANGE FOR PAYING THE
FUNDS BACK AT A LATER TIME. IN ESSENCE, THE BORROWER
HAS GAINED CONTROL OF THE USE OF MONEY THAT IS OWNED BY
THE LENDER. THIS INCLUDES THE OPPORTUNITY TO INVEST THIS
MONEY FOR THE PURPOSE OF EARNING INCOME FOR THE
BORROWER.
THE LENDER IS WILLING TO ENTER INTO SUCH A CONTRACT
BECAUSE INCOME FOR THE LENDER IS INVOLVED. THE
BORROWER AGREES TO PAY BACK MONEY IN ADDITION TO THE
AMOUNT OF MONEY BORROWED IN ORDER TO COMPENSATE THE
LENDER FOR PROVIDING THIS SERVICE. THE AMOUNT OF MONEY
THAT IS BORROWED IS CALLED PRINCIPLE. THE ADDITIONAL
AMOUNT THAT THE BORROWER AGREES TO PAY TO COMPENSATE
THE LENDER IS CALLED INTEREST.
THE AMOUNT OF THE INTEREST, AS A PERCENTAGE OF THE
PRINCIPLE AND ANNUALIZED, IS CALLED THE INTEREST RATE.
THIS CONCEPT IS KNOWN AS THE TIME VALUE OF MONEY.
TO THE BORROWER, INTEREST REPRESENTS A COST OF
BORROWING, CALLED INTEREST EXPENSE. TO THE LENDER,
INTEREST REPRESENTS INCOME ON AN INVESTMENT, SINCE THE
LENDER IS INVESTING FUNDS IN THE TRANSACTION IN ORDER TO
EARN INCOME. THIS IS CALLED INTEREST INCOME.
THIS ANALYSIS APPLIES TO THE BOND MARKET AS WELL AS SUCH
TRANSACTIONS AS BANK LOANS, BECAUSE BONDS ARE
ACTUALLY CONTRACTS BETWEEN LENDERS AND BORROWERS.
WHEN A BORROWER (DEBTOR) AND A LENDER (CREDITOR) ENTER
INTO A CONTRACT, THE BORROWER RECEIVES FUNDS AT THE
PRESENT TIME FROM THE LENDER IN EXCHANGE FOR PAYING THE
FUNDS BACK AT A LATER TIME. IN ESSENCE, THE BORROWER
HAS GAINED CONTROL OF THE USE OF MONEY THAT IS OWNED BY
THE LENDER. THIS INCLUDES THE OPPORTUNITY TO INVEST THIS
MONEY FOR THE PURPOSE OF EARNING INCOME FOR THE
BORROWER.
THE LENDER IS WILLING TO ENTER INTO SUCH A CONTRACT
BECAUSE INCOME FOR THE LENDER IS INVOLVED. THE
BORROWER AGREES TO PAY BACK MONEY IN ADDITION TO THE
AMOUNT OF MONEY BORROWED IN ORDER TO COMPENSATE THE
LENDER FOR PROVIDING THIS SERVICE. THE AMOUNT OF MONEY
THAT IS BORROWED IS CALLED PRINCIPLE. THE ADDITIONAL
AMOUNT THAT THE BORROWER AGREES TO PAY TO COMPENSATE
THE LENDER IS CALLED INTEREST.
THE AMOUNT OF THE INTEREST, AS A PERCENTAGE OF THE
PRINCIPLE AND ANNUALIZED, IS CALLED THE INTEREST RATE.
THIS CONCEPT IS KNOWN AS THE TIME VALUE OF MONEY.
TO THE BORROWER, INTEREST REPRESENTS A COST OF
BORROWING, CALLED INTEREST EXPENSE. TO THE LENDER,
INTEREST REPRESENTS INCOME ON AN INVESTMENT, SINCE THE
LENDER IS INVESTING FUNDS IN THE TRANSACTION IN ORDER TO
EARN INCOME. THIS IS CALLED INTEREST INCOME.
THIS ANALYSIS APPLIES TO THE BOND MARKET AS WELL AS SUCH
TRANSACTIONS AS BANK LOANS, BECAUSE BONDS ARE
ACTUALLY CONTRACTS BETWEEN LENDERS AND BORROWERS.