Interest has a different meaning depending on its purpose. For example, suppose we are talking about an investor or saver. In that case, the interest represents the compensation that they receive for having their money invested or applied, that is, for making their money available to third parties.
For those who make a loan, interest represents the cost of using the money that is lent to them by others, usually by the bank. The interest rate is a percentage of the invested/borrowed capital. It differs depending on the capital involved, the operation, and the risk, which is also influenced by macroeconomic factors.
Let’s learn more on how interest rates impact the economy and our money.
Types of interest rates
In the case of home loans, interest rates can take one of the following forms: variable interest rate, fixed interest rate, or mixed interest rate. In consumer loans, the interest rate charged can be fixed or variable.
- Variable interest rate: In loans with a variable interest rate, as the name implies, the interest rate varies depending on the reference rate.
- Fixed interest rate: In loans taken out at a fixed interest rate, the interest rate is always the same, and the value of the installment does not change during the term of the contract, with the customer knowing, from the outset, the total amount of interest to be paid.
- Mixed interest rate: In home loans contracted at a mixed interest rate, the parties agree that the credit agreement has a period in which the rate is fixed, followed by a period in which the rate is variable.
How are interest rates determined?
Interest rates are privileged vehicles for transmitting stimuli to the economy, controlling inflation and demand for money. They are directly influenced by the monetary policy defined by central banks.
The central bank makes money more expensive by increasing the key interest rate. Hence, people’s purchasing power decreases, consumption decisions are postponed, the use of credit is discouraged, and savings will yield higher interest rates. However, in the opposite scenario, money becomes cheaper when there is a decrease in the key interest rate. Consequently, the cost of borrowing is also reduced, thus stimulating household spending, business investment, and economic expansion.
Every six weeks, The Federal Reserve (specifically the Federal Open Market Committee or FOMC) sets the interest rates for the banking system. These decisions then have an impact on the interest rates charged by banks to customers.
Interest rates also affect our money and investments
Suppose the Central Bank announces an increase in interest rates. In that case, it is expected that there will be an early fall in the stock market since families and companies will reduce their consumption, generating expectations of lower profits for companies and investors and, consecutively, a decrease in the share price.
Stocks become less attractive, as the expected return may not compensate for the risk, especially when other investments appear to be safer and more predictable and allow for more satisfactory returns, such as deposits, bonds, or other debt securities.
When interest rates drop or are low, agents increase consumption and investment, with a greater propensity to invest in variable-yield products in the hope of obtaining a higher return, which translates into an appreciation of the stock market. In other words, the decrease in interest rates can mean an increase in the value of shares, not only because families have more money, which translates into a stimulus for the economy, but also because companies’ financing costs decrease, which can have a positive impact on the results of some companies, especially those that are more indebted.
Take note:
- When we talk about bank credit, interest rates represent the remuneration to be paid by the customer to the bank for the money lent to them. In addition to the interest rate, the customer will have to pay commissions and other fees associated with the loan.
- Banks provide information on interest rates, which are included in standard information sheets, before signing a credit agreement with the customer.
- In consumer credit, there are limits to the interest rates that can be charged, arising from the legal regime applicable in the US.