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What is Interest Rate? - Definition, Types & History

What is Interest Rate? - Definition, Types & History
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  • 0:00 Definition of Interest Rates
  • 0:45 The History of Interest Rates
  • 2:08 Types of Rates
  • 2:54 Components of Market…
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

Everything costs money, even money. In this lesson, you'll learn about interest rates - specifically, what they are, how they are determined, and what they mean for an individual and an economy.

Definition of Interest Rates

Interest rates, in the simplest terms, are the costs to borrow money or the return for lending money. Interest rates are percentages, although they are often referred to as points in finance lingo. For example, if mortgage rates went from 3% to 4%, amateurs would say 'rates went up one percent' while finance professionals would say 'rates went up a whole point.' There's a legitimate reason for that, not just so professionals sound fancy. Technically speaking, if mortgage rates were at 3% and they 'went up 1%', that means they went up 1% of 3%, so now they are 3.03% (.03% = 1% of 3%).

The History of Interest Rates

While mortgages and credit cards are relatively new financial instruments - developed within the last fifty years - interest rates have been around since the ancient civilizations. The need for interest rates arose from societies that started to build cities and farm the land, instead of following the herds like their hunter-gatherer ancestors. One person would grow grain and someone else would raise livestock. The person raising livestock wasn't paid until the livestock was grown and slaughtered, but they needed grain to get to that point. So, a system was created where the grain farmer would lend grain to the livestock rancher, who would then pay back his loan with goods he received by selling his livestock. No one shopped around for interest rates at that time - one grain farmer didn't charge a lower rate than the others. Instead, rates were set as laws. In Ancient Mesopotamia, the interest rate on grains was 20%.

Like the rest of the field of economics, the concepts of interest rates became significantly more complex during the industrial revolution. As businesses needed capital to grow, banks began fulfilling the role of moving capital from savers to borrowers and setting the rates based on the supply and demand of money. In the early 1900s the Federal Reserve Bank was formed, which took interest rates from a term in a loan agreement to a primary tool of monetary policy.

Types of Rates

There are many types of interest rates. Mortgage rates, auto loan rates, and credit card rates are all common rates that most people pay, and they each vary based on where you are, what you need it for, how much money you borrow, and your credit profile. Rates of return on savings accounts, money market accounts, investments, and bonds are all common interest rates many people are paid; but again, they vary based on many different factors. Finally, there are benchmark rates. These are rates that are set by central banks or other bodies that financial institutions use as a baseline for setting their own rates. Some examples of benchmark rates include the LIBOR rate, Fed Funds Rate, Prime Rate, and one-year treasury rate.

Components of Market Interest Rates

When a lender gives you a loan, they are forgoing some other use of their money so they can let you use it. Most lenders want to be compensated for that opportunity cost. The opportunity cost component is the first component of a market interest rate. Let's say I'm lending you $1,000 - instead of lending you the $1,000, I could buy a new laptop. I'm willing to forgo that laptop to lend you the money, but because I have to keep using my old desktop, I want $1 for each $100 you borrow. With just that, the interest rate is 1%.

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