Interest Rates are Interesting!

Interest rates certainly make for an interesting read!

Interest rates!

We all have heard of them and surely we all know what they are!

Ok, so quickly, lemme pose a question to you:

What are interest rates?

“Interest rates are return on investments and they compound!” – All you investor types are shouting

“Interest rates are what banks charge you when you borrow money from them” – All you banker types insist

“Interest rates reflect the appropriate compensation for the use of money so that it doesn’t lose its value in the face of inflation” – Grumble all you economist types

Well, guess what, you are all correct!

If you aren’t an investor, banker, economist or individual with an inkling of how the financial system works, let’s make this simple:

Interest is the additional value that the lender makes when lending money to the borrower.

So let’s use a really simple example:

Johnny puts $1,000 in a term deposit with a bank. Term deposits are bank accounts you put money into for a minimum period of at least 6 months or 1 year and can go up to 5 to 7 years. This means that Johnny is putting his money away for some time and won’t be touching it. Let’s say that in this example, Johnny is putting his money in a 1 year term deposit.

So recall our previous lesson about how money loses value over time? Since Johnny is putting his money away in the bank for some time, he wants to make sure his money doesn’t lose its value. To compensate for this the bank gives him a sweet interest rate of 4%.  This 4% is calculated off the money balance in the term deposit. So, 4% of $1,000 is:

4% X $1,000 = $40

This means that at the end of the 1 year, Johnny’s $1,000 will be $1040.

You see, when Johnny deposits money with the bank, what he is doing is that he is effectively lending the bank money. The bank then has to compensate him with additional value (interest) to cover inflation and the general decrease over the time value of money.

This works in reverse as well, when banks lend money to people or businesses, they charge an interest rate so that we (the borrowers) compensate them with additional value to cover inflation and the general decrease over the time value of money. This interest rate that borrowers pay to the bank is a form of expense and is totally tax-deductible!

Banks will always charge more interest on their loans than they would give on their deposits because as a business, the interest charged on their loans is their main way of making income (remember income?) to pay their expenses and make a profit!

The following picture best describes how banks work and how they use interest rates to make money:

Banks take money from depositors when they open up bank accounts, they then lend that same money to anyone who wants to borrow money. They charge an interest on the loan they make to the borrower and then pay (a much lower) interest to the depositor (that is assuming that depositors even open up an account that pays interest!) – sneaky!

Interest rates can also be described as a type of ‘Return on Investment’ (ROI). Lending money to someone is a form of investment as you expect that whatever money you lend to them will be paid back with interest (thus giving you a nice return!).

Pictured: How loans work

So there you go: Interest rates are quite interesting and now you can talk to your show-off ‘Invest-Or’ brother in law about how interest rates really work. Hah!

You might have some questions about the government lowering/raising interest rates in order to stimulate the economy or whatever, but let’s leave the lesson here for today and come back to that in a future date. : D

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