Interest Rates Explained: What It Is & How It Affects You
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Let’s talk about the interest rate.
In particular, I want to talk about
how interest rate fluctuations affect you?
what are the causes behind these interest rate movements?
1. How will the interest rate fluctuations affect you
To understand how will the interest rate fluctuations affect you, you have to first understand what interest rates are and why it matters.
To put it simply, the interest rate is essentially the price of money.
It is the price that you will have to pay when you borrow money from others or it is the price that you receive when you lend money to others.
That said, generally, a rising interest rate is not beneficial to most of us who have a large amount of borrowing – mainly for our housing mortgage – as the price that we will be paying on our loans will be higher.
In addition, a higher interest rate will also cause the economy to slow down as companies face a higher cost of borrowing which in turn affects their bottom line.
If you are a business owner, your company’s operation and sales may start to slow down which will may result in lower profitability.
If you are an employee, if your company slows down, it will also indirectly affect you as well in terms of job progression and job stability.
That is why understanding the behaviour and level of the current interest rate is important even if you are not an investor.
2. What causes the interest rate to go up/down
So, what causes the interest rate to fluctuate. What causes it to go up and what causes it to down?
Generally speaking, there are three key factors that affect the behaviour of the prevailing interest rate.
The first is the supply and demand for money. The second is the inflation rate and the third is the central banks or the government’s interest and inflation rate targets.
Let’s go through them one by one.
2.1 The supply of and demand for money (credit).
Now the thing about pricing money or determining the interest rate is that it is not that different from pricing goods and services.
At the end of the day, it boils down to basic economics – demand and supply.
If there is more demand for money than there are in supply, the interest rate will increase as people are willing to pay a higher price to secure the limited borrowings available.
If there is more supply of money than there are in demand, the interest rate will decrease as lenders need to lower the price of money to attract borrowers to borrow.
Generally, to determine the future direction of interest rate, you have to understand what the likely demand and supply of money would be in the near future.
However, do take note that there are only two types of participants in the market of money. Those that use it and those that issue it.
Participants that use money are like your companies, business and ordinary consumers like you and me. We need that money to facilitate the day-to-day transaction and we cannot, by any legal means, create the money on our own.
Having said that it means that the supply from money users is limited but the demand from money users is unlimited.
On the other hand, the participant that issues money is your central bank.
As a money issuer, they have no need for the money that they can easily create and because of that the supply from a money issuer can be unlimited but the demand for money depends on their intention and their motivation.
I’ll elaborate abet more on the point of central banks and governments later on.
For now, let us move on to the next point
For the benefit of those who are new to finance, inflation is the decline of purchasing power of a given currency over time. The inflation rate is the rate that measures the extent to which your purchasing power changes – be it for the better or the worst.
The best example I can give you was that 10 years ago, Bic mac costs $5 but now it costs around $8. That $3 differences are what we call inflation and essentially the inflation rate is around 60%.
So how does the inflation rate or expected inflation rate affect the interest rate behaviour?
For you to understand how this work, you have to see things from the point of the lender.
Now imagine that you are going to lend your friend $100,000 today to start his business, in exchange your friend promises to pay you $120,000 ($100,000 in principal and $20,000 in interest) at the end of 5 years which is what you need to maybe buy the car that you always wanted to have.
Now before you agree to the interest return of $20,000, you suddenly realize that the price of the car that you wanted will increase from $120,000 to $130,000 in 5 years.
Now you have a problem, if you were to lend your friend at the original interest return of $20,000, you will not have enough money to offset the increase in the cost of the car in 5 years.
So, what will you do?
The obvious thing for you to do is to transfer the expected increase in the cost of the car to your friend and raise the interest return from $20,000 to $30,000.
So, at the end of the day, while you are still able to fulfil what you originally wanted with the loan agreement, your friend now has to bear on a higher interest rate.
That is how inflation rate and expectations affect the interest rate. As the inflation rate increases, lenders will want to be compensated for the loss of purchasing power and as such will raise their interest rate to price in the differences.
History has shown that there is a very high correlation between inflation rate and interest rate as you can see here.
2.3 Government’s interest & inflation target rate
The third factor that could influence the interest rates is the role that the government plays as part of the market participant.
Recall earlier that there are only two types of market participants in the market of money, those that use it and those that issue it.
And those that issues it, like that of the central bank and government, has no demand for it but has an unlimited supply of it.
In the case of the government’s interest when it comes to the money market and interest rates, they use it as a form of instrument and tool to influence the economy and the behaviour of the participants that use the very money that they issue.
For example, if the government would like to stimulate the economy, all they need to do is to lower the interest rates by flooding the market with cheap and easy money. With an increase in the supply of money in the market, the price of money – interest rate – will naturally decrease.
Similarly, if the government wish to slow down the economy, all they need to do is to increase the interest rate by extracting money out of the system. With a decrease in the supply of money in the market, the price of money – interest rate – will naturally increase.
This is why everybody pays a lot of attention as to what the government’s target is when it comes to the interest rate as they have all the measures at their disposal to bend the rates to their targets given that they have an unlimited supply of the very money that they issue or print.
This is also why everybody pays a lot of attention to the inflation target rate as oftentimes inflation is seen as a measure of whether the economy is doing well or badly. Based on the inflation rate situation, the government will then turn their attention to the interest rates to fulfil their original economy targets.
Long story short, the interest rate is something that affects us directly – via our borrowing cost - and also indirectly – via the economy.
It will be wise for you to pay attention to what is happening in the economy to determine whether or not you should be more aggressive or defensive about things like
career or industry switch
leveraging to invest (Property / Annuity)
Daniel is a Licensed Independent Financial Consultant with MAS and a certified Associate Wealth Planner that provides:
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This article is meant to be the opinion of the author
This article is for information purposes only
This article should not be seen as financial advice
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