Investment Fundamentals: Interest Rates

June 25, 2014

An interest rate is a measure of the compensation that lenders receive from borrowers in exchange for a loan.

  • Interest rates represent the cost to borrow money. 
  • Longer-term loans tend to have higher interest rates than short-term loans to compensate for increased risks.
  • The Federal Reserve can encourage employment and price stability through control of short-term interest rates.

An interest rate is a measure of the compensation that lenders receive from borrowers in exchange for a loan. The rate is expressed as a percentage of the principal, or loan amount. Consumers can choose to finance large purchases, like home mortgages or auto loans, at a fixed interest rate over a multi-year term. Such a loan might come with an interest rate of 4%. Many also use smaller loans that have no specified term, such as credit-card debt. For these loans, interest rates in the double digits are not uncommon.

Loans and Lenders

While most people get loans from a bank, large institutions can often achieve their financing needs in a more cost-effective manner by issuing bonds to investors. The U.S. government, for example, issues Treasury bonds. Many companies also issue bonds, known as corporate bonds, to finance ongoing or expansion-related activities.

How Interest Rates are Determined

The Federal Reserve (Fed) sets the fed funds rate, a short-term interest rate for borrowing and lending between major banks, which serves as a reference point for most other financing activity in the U.S.

High interest rates can be used to slow price increases by reducing the demand for borrowed money.

Decisions on whether to change the fed funds rate depend generally on the conditions of two factors: Employment and price stability. The fed funds rate can be lowered to spur economic growth via inexpensive borrowing costs, which makes job-creating activities more feasible for established companies and entrepreneurs. But lowering rates also risks stoking inflation, or rising prices, as the supply of borrowed money available for spending increases.

Higher interest rates, on the other hand, can be used to slow price increases by reducing the demand for borrowed money. At the same time, job creation would suffer, so the Fed’s rate-setting decisions require a delicate balancing act.

Creditworthiness, or the likelihood that a borrower will repay a loan, is an important element of a lender’s interest rate decision. A more creditworthy borrower will often be able to attain a lower rate than a less creditworthy borrower. Defaults (failure to make scheduled payments), total debt load and ability to repay are core factors of creditworthiness.

Loan length, also referred to as term or maturity, is another key determinant in setting interest rates. Exhibit 1 shows the U.S. Treasury yield curve, a visual depiction of the prevailing rates across the entire range of available Treasury maturities. It reveals how rates for these securities rise as the terms increase.

 us treasury rates

 

 

 

Source: U.S. Treasury, SEI. Data as of 6/12/14.

There is greater risk associated with longer-term loans. As the length of a loan grows, the amount of time during which the borrower could default increases as well. Also, longer-term loans require lenders to forsake liquidity, or the ability to quickly convert assets to cash, which could force them to miss more favorable opportunities. Finally, long-term fixed-rate loans put lenders at a disadvantage if interest rates rise after they lock into a loan agreement, which represents an example of how expectations for Fed rate-setting decisions affect borrowers and lenders. Accordingly, lenders demand higher interest rates for long-term loans.

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Information provided by SEI Investments Management Corporation (SIMC), a wholly owned subsidiary of SEI.

This information should not be relied upon by the reader as research or investment advice, nor should it be construed as a recommendation to purchase or sell a security.

There are risks involved with investing, including loss of principal. Bonds and bond funds will decrease in value as interest rates rise.