4. Interest Rates

Every state has very specific limits on the amount of interest that may be charged on consumer contracts, ranging anywhere from five to 15 percent. But because parties may always agree to interest rates that are above the legal limit, most consumer contracts include interest rates that are above that limit.

Thus few states have limits on what can be expressly agreed to in a contract. For example, Alaska limits express contract terms to five percent over the legal rate, while the District of Columbia has the highest stated ceiling, at 24 percent. A number of states allow the limit to be pegged to the rate set by the Federal Reserve Board; most of these states have limits of five percent above the Federal Reserve. Potentially, these may be much higher than the District of Columbia’s 24 percent. Overall, it appears that the more rural the state, the lower the limits. Presumably, farmers are protected and are more secure with lower interest rates than citizens of generally urban states with larger economies.

Usury is an unconscionable and exorbitant rate or amount of interest which exceeds those permitted by law. There is a great variety of statutory remedies for usury. A few states class usury as a crime and prescribe prison for violations of its usury laws. The majority of states provide for economic remedies such as forfeiture of all interest paid, recovery of double the usurious amount, payment of a fine, or making the contract unenforceable. Some states even specify that banks or savings and loans pay penalties. North Dakota has one of the more extreme usury penalties: it requires payment of all interest plus 25 percent of the principal.

For the most part there are myriad exceptions to the legal interest rate, which may be tied to the character of the lender, borrower, loan amount, the nature of the contract, or the matter that is the subject of the contract. Effectively, legal interest rates are no more than general guidelines for all transactions rather than the specific limits placed on them. There are so many exceptions in many states that it is often necessary to find a different rate for every conceivable situation.

Interest Rates

Lenders of money profit from such transactions by arranging for the borrower to pay back an additional amount of money over and above the sum that they borrow. This difference between what is lent and what is returned is known as interest. The interest on a loan is determined through the establishment of an interest rate, which is expressed as a percentage of the amount of the loan.

Borrowing is a staple in many arenas of the U.S. economy. This has resulted in a dizzying array of borrowing arrangements, many of which feature unique wrinkles in the realm of interest rates. Common borrowing and lending arrangements include business and personal loans (from government agencies, banks, and commercial finance companies), credit cards (from corporations), mortgages, various federal and municipal government obligations, and corporate bonds. In addition, interest is used to reward investors and others who place money in savings accounts, individual retirement accounts (IRAs), Certificates of Deposit (CDs), and many other financial vehicles.

TYPES OF INTEREST RATES

The "prime rate" is probably the best-known interest rate. It is the rate at which commercial banks lend money to their best—most creditworthy—customers. However, in order to track interest rates logically, one should start with the Federal Reserve's "discount rate." The discount rate is the interest rate that banks are charged when they borrow money overnight from one of the Federal Reserve Banks. There are twelve Federal Reserve Banks, each of which is a part of the nation's central bank and plays a part in setting the monetary policy of the United States.

Commercial banks pass along the cost of borrowing money when they establish the rates at which they lend money. One factor in establishing those rates is the discount rate established by the Federal Reserve Bank, although other factors play into the calculation. The prime rate is the lowest rate at which commercial banks lend. Although often thought of as a set interest rate, the prime lending rate is not actually a uniform rate. National City Bank may, for example, have one rate while CitiBank has another slightly different rate. As a result, the most widely quoted prime rate figure in the United States is the one published in the Wall Street Journal. What they publish is an average rate that results from polling the nation's thirty largest banks; when twenty-three of those institutions have changed their prime rates, the Wall Street Journal responds by updating the published rate. The reason that the prime rate is so well known is that it is used as a basis off of which most other interest rates are calculated.

Other important interest rates that are used in making capital investment decisions include:

• Commercial Paper Rate—These are short-term discount bonds issued by established corporate borrowers. These bonds mature in six months or less.
• Treasury Bill Rate—A Treasury bill is a short-term (one year or less) risk-free bond issued by the U.S. government. Treasury bills are made available to buyers at a price that is less than its redemption value upon maturity.
• Treasury Bond Rate—Unlike the short-term Treasury bills, Treasury bonds are bonds that do not mature for at least one year, and most of them have a duration of 10 to 30 years. The interest rates on these bonds vary depending on their maturity.
• Corporate Bond Rate—The interest rate on long-term corporate bonds can vary depending on a number of factors, including the time to maturity (20 years is the norm for corporate bonds) and risk classification.

How interest rates are established, why they fluctuate, and why they vary from lender to lender and borrower to borrower are complicated matters. Two terms used in banking whose definitions it will be helpful to know in reading further about interest rates are "real" and "nominal." The "real" interest rate on a loan is the current interest rate minus inflation. It is, in essence, the effective rate for the duration of the loan. The "nominal" interest rate is the rate that appears on the loan agreements, the stated rate that does not account in any way for inflation.

FACTORS THAT INFLUENCE INTEREST RATES

Interest rate levels are determined by the laws of supply and demand and fluctuate as supply and demand change. In an economic environment in which demand for loans is high, lending institutions are able to command more lucrative lending arrangements. Conversely, when banks and other institutions find that the market for loans is a tepid one (or worse), interest rates are typically lowered accordingly to encourage businesses and individuals to take out loans.

Interest rates are a key instrument of American fiscal policy. The Federal Reserve determines the interest rate at which the federal government will bestow loans, and banks and other financial institutions, which establish their own interest rates to parallel those of the "Fed," typically follow suit. This ripple effect can have a dramatic impact on the U.S. economy. In a recessionary climate, for instance, the Federal Reserve might lower interest rates in order to create an environment that encourages spending. Conversely, the Federal Reserve often implements interest rate hikes when its board members become concerned that the economy is "overheating" and prone to inflation.

By raising or lowering its discount interest rate on loans to banks, the Federal Reserve can make it attractive or unattractive for banks to borrow funds. By influencing the commercial bank's cost of money, changes in the discount rate tend to influence the whole structure of interest rates, either tightening or loosening money. When interest rates are high, we have what we call tight money. This means not only that borrowers have to pay higher rates, but that banks are more selective in judging the creditworthiness of businesses applying for loans. Conversely, when interest rates decline, money is called easy, meaning that it is both cheaper and easier to borrow. The monetary tools of the Federal Reserve work most directly on short-term interest rates. Interest rates charged for loans of longer duration are indirectly affected through the market's perception of government policy and its impact on the economy.

Another key factor in determining interest rates is the lending agency's confidence that the money—and the interest on that money—will be paid in full and in a timely fashion. Default risk encompasses a wide range of circumstances, from borrowers who completely fail to fulfill their obligations to those that are merely late with a scheduled payment. If lenders are uncertain about the borrower's ability to adhere to the specifications of the loan arrangement, they will often demand a higher rate of return or risk premium. Borrowers with an established credit history, on the other hand, qualify for what is known as the prime interest rate, which is a low interest rate.

TERM STRUCTURE OF INTEREST RATES

The actual interest on a loan is not fully known until the duration of the borrowing arrangement has been specified. Interest rates on loans are typically figured on an annual basis, though other periods are sometimes specified. This does not mean that the loan is supposed to be paid back in a year; indeed, many loans—especially in the realm of small business—do not mature for five or ten years, or even longer. Rather, it refers to the frequency with which the interest and "principal owed"—the original amount borrowed—are recalculated according to the terms of the loan.

Interest is usually charged in such a way that both the principal lent and the accrued interest is used to calculate future interest owed. This is called compounding. For small business owners and other borrowers, this means that the unpaid interest due on the principal is added to that base figure in determining interest for future payments. Most loans are arranged so that interest is compounded on an annual basis, but in some instances, shorter periods are used. These latter arrangements are more beneficial to the loaner than to the borrower, for they require the borrower to pay more money in the long run.

While annual compound interest is the accepted measure of interest rates, other equations are sometimes used. The yield or interest rate on bonds, for instance, is normally computed on a semiannual basis, and then converted to an annual rate by multiplying by two. This is called simple interest. Another form of interest arrangement is one in which the interest is "discounted in advance." In such instances, the interest is deducted from the principal, and the borrower receives the net amount. The borrower thus ends up paying off the interest on the loan at the very beginning of the transaction. A third interest payment method is known as a floating- or variable-rate agreement. Under this common type of business loan, the interest rate is not fixed. Instead, it moves with the bank's prime rate in accordance with the terms of the loan agreement. A small business owner might, for instance, agree to a loan in which the interest on the loan would be the prime rate plus 3 percent. Since the prime rate is subject to change over the life of the loan, interest would be calculated and adjusted on a daily basis.

THE INTEREST RATE AND SMALL BUSINESSES

Entrepreneurs and small business owners often turn to loans in order to establish or expand their business ventures. Business enterprises that choose this method of securing funding, which is commonly called debt financing, need to be aware of all components of those loan agreements, including the interest.

Business consultants point out that interest paid on debt financing is tax deductible. This can save entrepreneurs and small business owners thousands of dollars at tax time, and analysts urge business owners to factor those savings in when weighing their company's capacity to accrue debt. But other interest rate elements can cut into those tax savings if borrowers are not careful. Because interest paid on a loan is tax deductible, while other loan charges and fees are not, it may be in the best interest of a small business owner to accept a loan with a slightly higher interest rate if it offers fewer handling charges than a similar loan with a slightly lower interest rate but higher handling fees. The full impact of loan charges and interest rates over time should be made before deciding upon a lender.

Commercial banks remain the primary source of loans for small business firms in America, especially for short-term loans. Small business enterprises who are able to secure loans from these lenders must also be prepared to negotiate several important aspects of the loan agreement which directly impact interest rate payments. Both the interest rate itself and the schedule under which the loan will be repaid are, of course, integral factors in determining the ultimate cost of the loan to the borrower, but a third important subject of negotiation between the borrowing firm and the bank concerns the manner in which the interest on a loan is actually paid. There are three primary methods by which the borrowing company can pay back interest on a loan to a bank: a simple- or ordinary-interest plan, a discounted-interest plan, or a floating interest rate plan.

Securing long-term financing is more problematic for many entrepreneurs and small business owners, and this is reflected in the interest rate arrangements that they must accept in order to secure such financing. Small businesses are often viewed by creditors as having an uncertain future, and making an extended-term loan to such a business means being locked into a high-risk agreement for a prolonged period. To make this type of loan, a lender will want to feel comfortable with the business, the quality of its management, and will want to be compensated for what it sees as higher-than-usual risk exposure. This compensation usually includes the imposition of interest rates that are considerably higher than those charged for short-term financing. As with short-term financing arrangements, interest on long-term agreements can range from floating interest plans to those tied to a fixed rate. The actual cost of the interest rate method that is ultimately chosen appears in interest rate disclosures (which are required by law) as a figure known as the annual percentage rate (APR).

see also Banks and Banking; Credit; Loans

BIBLIOGRAPHY

Cooper, James C. "U.S.: From Here On Out, The Fed Is Winging It; More uncertainty over future rate decisions will mean bumpier markets." Business Week. 10 April 2006.

Federal Reserve Board of the United States. Discount Rate. Available from http://www.federalreserve.gov/monetarypolicy/discountrate.htm 16 March 2006.

Walter, Robert. Financing Your Small Business. Barron's Educational Series, March 2004.

                           Hillstrom, Northern Lights

                           updated by Magee, ECDI

Interest Rates

INTEREST AND PROFITS

INTEREST AND MONEY

INTEREST RATES AS A LINK WITH THE FUTURE

MONETARY POLICY

BIBLIOGRAPHY

In everyday language, interest is the payment, made by the borrower of a sum of money to the lender, that is in addition to the repayment of the amount borrowed. The rate of interest is the price of loans, a critical economic variable. However, its importance extends beyond economics. Payment of interest has been a major issue in ethics, and the Jewish, Christian, and Islamic religions have all had, at least for long periods of their history, outright prohibitions on demanding interest when making loans. The dominant nature of interest varies according to the culture of the society in which it is set. For example, loans made to people who are in need and face severe hardship if they cannot get a loan are an essentially different type of transaction from loans that are made to an entrepreneur to finance business operations that are confidently expected to be profitable. This entry will concentrate on the nature and role of interest in modern market economics.

In technical economic language, interest is a payment for the use of capital, with the rate of interest the price paid for this use. Except in some specialized contexts, interest is a financial variable paid for the use of financial capital or money. Economists often talk of the rate of interest. In practice there is not one rate of interest but many, and the form of the transaction can vary from the usual. For example, one way in which banks borrow is by selling bank bills, or a promise to pay the holder of the bill a stated amount at a stated date in future. The difference between the amount paid for a bank bill and the amount the bank pays back on maturity is the interest on the loan to the bank. Also, of course, interest rates can be on loans of any length of time. Loans from overnight to ten years are common, but some are indefinite, with no commitment ever to repay the money. In addition to the amount paid for the use of capital, interest rates often incorporate a risk premium to compensate the lender for bearing the risk that the capital may not be repaid promptly or at all. The risk of most national governments defaulting is practically zero, so the interest rate they pay can be taken as a measure of the pure interest part of an interest rate.

INTEREST AND PROFITS

Since the interest rate is a financial variable, one would expect that interest rates are determined by the demand for, and supply of, loans and other financial assets. However, at least since the work of Adam Smith (1723–1790) in the late eighteenth century, the dominant view among economists has been that interest rates will tend toward a figure determined by profits. In equilibrium—that is, in a situation where there is no tendency to change—the rate of interest is equal to the rate of profit on the use of new physical capital goods. Hence, despite disturbances caused by purely financial factors, interest rates are largely determined by nonfinancial or real factors.

The modern form of the theory underlying this process is based on the work of Swedish economist Knut Wicksell (1851–1926). In his pathbreaking book Interest and Prices (1898), Wicksell was concerned with explaining trends in prices. Wicksell calls the interest rate fixed by financial markets the money rate of interest, and the interest rate determined by real factors the natural rate of interest. He starts with a situation in which the money rate is equal to the natural rate. Wicksell then assumes an increase in the natural rate due, say, to a new innovation increasing the productivity of capital goods. The money rate is assumed to remain unchanged. Since the new capital goods are more productive and the interest costs are unchanged, profits will increase, leading to an increased demand for new capital goods in the next period.

Like most other economists of his time, Wicksell thought that the economy was always more or less in a state where there was full employment of both labor and capital. Hence, an increased demand for new capital goods will raise their prices. The incomes of those supplying capital goods will increase, and they will spend more on consumer goods, raising the prices of consumer goods. The money rate of interest has not changed, so it is still profitable to borrow to cover any higher prices of inputs, and the whole process will continue until the banking system raises interest rates to the extent required to make the money rate equal to the natural rate. The reverse process occurs if the money rate is greater than the natural rate and causes falling prices. In both cases, equilibrium is only reached when the money rate of interest changes to be equal to the natural rate, which itself is equal to the profit rate on new capital goods.

This analysis of how a divergence between the natural and money rates of interest causes cumulative movements in prices can be adapted to explain changes in the rate of inflation from some rate widely accepted as normal. It can even include relaxation of the assumption of full employment, as long as any lapses are temporary and are automatically removed by the functioning of the economy. In this analysis, interest is the price that equates the supply of funds from net savings with the demand for funds for investment in new capital goods.

INTEREST AND MONEY

John Maynard Keynes’s (1883–1946) enormously influential General Theory of Employment, Interest, and Money (1936), among other things, turned the focus of interest rate theory onto financial markets. In contrast to Wicksell’s analysis, Keynes focused attention on why people want to hold money rather than other financial assets such as bonds. The reason for holding money is that it is completely liquid. One can use it immediately. Keynes listed three reasons for desiring liquidity. One is the transaction motive : to make easy both commercial and personal exchanges. Another is the precautionary motive : to have the ability to respond immediately to unforeseen future needs. The last reason is the speculative motive : to try and make a profit by guessing or knowing the future better than the market as a whole. Keynes thought that the major influence on interest rates in the short run was that arising from speculation on the level of future interest rates.

Not surprisingly, given the institutional arrangements of his time, Keynes thought that the volume of money in a country was determined by the central bank. This supply of money, together with the demand for money, especially that resulting from liquidity preference, determined the rate of interest. Today, institutional arrangements are very different. The ability of financial markets to create money is determined by the demand for money, with external constraints much less important. Central banks now rely on more direct ways of influencing interest rates, mainly using changes in the interest rate they charge banks who borrow from them. Nevertheless, Keynes’s emphasis on monetary factors and the allocation of assets remains important.

Fitting together the two theories by using monetary factors to explain interest rates in the short run and real influences to explain interest rates in the longer run does justice to neither theory. In both cases, the determination of the rate of interest is an integral part of the bigger whole. Keynesian economists deny the proposition that the economy trends strongly toward the full-employment position, which is a crucial part of the theory in the Wicksellian tradition. If the Keynesian view is correct and there can be continuing equilibrium at less than full employment, then causation will run more from interest rates determined in financial markets to real variables like output and capital productivity than the reverse. The different theories have very different implications for monetary policy.

INTEREST RATES AS A LINK WITH THE FUTURE

Irrespective of how it is determined, the interest rate has a crucial role to play in the allocation of new capital goods. Businesspeople will only buy new capital goods if the expected profit rate on those goods is equal to or greater than the rate of interest. The rate of interest sets the hurdle that determines which of the myriad ways in which new capital can be used are realized. Thus, the interest rate determines now what types of new capital goods there will be in the future, when the output these capital goods help to produce comes on the market.

So far this entry has not discussed the situation where the money borrowed is used to buy consumer goods, rather than capital goods. Here too the interest rate has a role to play in linking the present and the future. A person may borrow to increase current consumption because future income is expected to be greater than present income or future needs to be less than present needs. Alternatively, the borrower may give more weight to consumption in the present than to consumption in the future. The price of consuming more now is given by the interest rate. Generally, the higher the interest rate the less consumption is shifted from the future to the present, though the strength of the relationship may not be strong and for many individuals the desire to consume now may result in future consumption being discounted enough to outweigh any likely rate of interest.

Interest rates can also play a role in decisions about government expenditures and other policies, such as a tariff on imports of a particular commodity or the introduction of restrictions on logging. Cost-benefit analysis can be used to evaluate policy decisions, taking into account wider social criteria and not only narrow economic benefits and costs. There are many technical problems in estimating the various costs and benefits of a particular policy change. The one that is relevant here arises because many costs and benefits will occur in the future. In many cases, more of the costs occur in the near future compared to the benefits, so the choice of the interest rate used to discount future flows of costs and benefits has a major effect on the result. Some argue that the after-tax interest return on risk-free government bonds less the rate of inflation should be used in such analyses. Others argue that, because this is a market rate of interest, it incorporates a higher rate of discounting the future than is appropriate for a social discount rate.

MONETARY POLICY

The precise way monetary policy operates depends on the institutional arrangements of financial markets, but there is now widespread agreement that the immediate target of monetary policy is the level of interest rates. The dominant view among economists is that the underlying objective of monetary policy should be to contain inflation, often to keep it in a publicly announced target range. In Wicksellian terms, the objective is to keep the money rate close to the natural rate.

Orthodoxy also allows that, when employment is markedly below full employment, monetary policy can help hasten the return to full employment. Keynesian economists hold that, in the absence of policies to prevent it, a market economy can remain well below the full-employment level indefinitely. For them, monetary policy has a part to play in restoring full employment.

In countries with floating exchange rates, monetary policy may also be used to support the exchange rate. A freely floating exchange rate, where transactions are not constrained by any controls on capital transactions, is a very flexible price, responding quickly to changes in supply and demand. In the modern global economy, the vast majority of foreign exchange transactions are investments in financial markets where the returns are high. The return to investing foreign funds in a country is the rate of interest obtained in the country plus the expected appreciation of the country’s currency in foreign exchange markets (or less any expected depreciation). Thus, other things being equal, a rise in interest rates will lead to a higher exchange rate or prevent or reduce a fall in exchange rates if depreciation is expected. There have been clear examples of countries raising interest rates to very high levels to prevent a disastrous fall in exchange rates. Behind the scenes, use of monetary policy to support the exchange rate may be more widespread.

In the traditional story, interest rate changes affect inflation and economic activity through their influence on investment in new capital goods. The implication is that this investment is made by businesses. In fact, an interest rate change usually has a stronger direct effect on residential construction by households. It may also affect credit card usage and other forms of household debt.

A second way a change in interest rates can influence the economy is its effect on bank assets. The value of existing financial assets goes down when interest rates rise. When the values of banks’ assets fall, banks are less willing to lend, and a slight or a serious credit squeeze occurs. Many economists think that the availability of credit is more important than the level of the interest rate in transmitting the effects of changes in monetary policy.

The exchange rate also has a part to play in transmitting the effects of changes in the rate of interest. If interest rates rise, the value of a country’s currency will rise on foreign exchange markets. This will make imports cheaper and reduce the return to exports. The low prices for imports will help restrain inflation, and the lower returns in exporting and import-competing industries will discourage investment in these industries.

The exchange rate also has a major influence on the efficacy of monetary policy, especially in the case of small countries with many economic links to the outside world. If the exchange rate is fixed and expected to stay fixed at its current value, monetary policy relies on capital controls to stop people borrowing in foreign countries. Consequently, monetary policy is usually not effective.

On the other hand, if a country has a freely floating exchange rate, problems arise if a major depreciation of the value of its currency is expected in financial markets. In this situation, monetary policy may have to ignore its usual goals and focus solely on supporting the exchange rate.

More generally, globalization has reduced the efficacy of monetary policy. For example, if rising interest rates reduce the availability of credit from domestic sources, this will be offset to some extent by the willingness of foreigners to lend. The biggest problem is probably the risk that policy aimed at expanding economic activity by reducing interest rates may lead to expectations of a depreciation in the value of a country’s currency. Some depreciation is usually helpful in these circumstances, but a large depreciation can have a serious impact, especially on the distribution of income. The desire to avoid such an impact may hamstring monetary policy in some circumstances. Nevertheless, the general view is that governments still have considerable freedom in domestic macroeconomic management, but since the efficacy of monetary policy has been reduced significantly, more reliance may have to be placed on other policies.

A different aspect of the operation of monetary policy has attracted considerable attention: its effect on the relationship between short-term and long-term interest rates. This relationship is usually called the term structure of interest rates or the yield curve. Central bank operations directly influence short-term interest rates. When the actions of the central bank raise short-term interest rates, longer-term rates may not rise much, since the rises at the short-term end of the market are often considered temporary and liable to be reversed when policy changes. Normally, interest rates rise as the term of the loan lengthens, probably due to increased uncertainty about the level of interest rates in the more distant future. Thus the yield curve slopes upward as the loan lengthens. For the reasons given above, tight monetary policy can flatten, or even invert, the yield curve. Many studies have documented a historical relationship linking a flat or inverted yield curve with a recession somewhat later. Interest has arisen in using the yield curve to predict the level of activity in the genuinely unknown future, but this is a much more difficult exercise.

SEE ALSO Balance of Payments; Cambridge Capital Controversy; Central Banks; Cost-Benefit Analysis; Currency; Economics, Keynesian; Exchange Rates; Interest, Natural Rate of; Interest, Neutral Rate of; Interest, Own Rate of; Interest, Real Rate of; Interest Rates, Nominal; Keynes, John Maynard; Liquidity; Macroeconomics; Policy, Monetary; Profitability; Recession; Solow, Robert M.; Taylor, Lance; Yield Curve

BIBLIOGRAPHY

Chick, Victoria. 1983. Macroeconomics after Keynes: A Reconsideration of the General Theory (chaps. 9–11). Oxford: Philip Allan.

Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money (chaps. 13–15). London: Macmillan.

Kriesler, Peter, and J. W. Nevile. 2003. Macroeconomic Impacts of Globalization. In Growth and Development in the Global Economy, ed. Harry Bloch, 173–189. Cheltenham, U.K.: Elgar.

Macfarlane, Ian, and Glenn Stevens. 1989. Overview: Monetary Policy and the Economy. In Studies in Money and Credit, eds. Ian Macfarlane and Glenn Stevens. Sydney: Reserve Bank of Australia.

Solow, Robert M. 1997. Is there a Core of Usable Macroeconomics We Should All Believe In? American Economic Review 87: 230–232.

Taylor, Lance. 2004. Reconstructing Macroeconomics: Structuralist Proposals and Critiques of the Mainstream (chaps. 3 and 10). Cambridge, MA: Harvard University Press.

Wicksell, Knut. [1898] 1936. Interest and Prices (Geldzins and Güterpreise): A Study of the Causes Regulating the Value of Money. Trans. R. F. Kahn. New York: A. M. Kelly.

J. W. Nevile

Interest Rates

Sections within this essay:

Background

In the world of banking and finance, interest is money that is paid by a borrower to a lender in exchange for the use of the credit. Money held in an account, such as a bank savings or checking account, may earn interest also because the bank has use of the money while it is held in the account and the interest constitutes payment to the account holder for the temporary use of the money.

Typically, interest is computed as a percentage of the amount borrowed, which is known as the principal. Interest may be computed on a yearly basis, which is known as simple interest. For example, if a borrower borrows $1,000 at a simple interest rate of 12 percent, with the loan due to be repaid in one year, the total interest owed on the loan is $120. Alternatively, interest may be compounded. With compounded interest, the calculation of interest occurs periodically and unpaid interest is added to the premium. For example, assuming a loan of $1,000 with a 12 percent interest rate compounded monthly, the interest that accrues during the first month of the loan is $120. That amount is added to the principal, making the total amount $1,120. The interest accruing during the second month of the loan—12 percent of $1,120—is $134.40. With compounded interest, the interest rate stays the same but the amount of interest may increase periodically.

History

Interest on borrowed funds has existed since ancient times, but interest was not always an acceptable means of conducting business. Religious groups in the Middle Ages—Jewish, Christian, and Islamic—forbade the use of interest, considering it reprehensible. Romans in ancient times also outlawed the practice of charging interest, as did the English government until the thirteenth century. In time, and with increasing demands for credit to support the growth of commerce and trade, a distinction was made between moderate interest rates and excessive interest rates. Chinese and Hindu laws prohibited excessive interest rates, known as usury, and in 1545, England set a maximum rate of interest. Other countries followed England's practice. In the United States as of 2002, the payment of interest for loans is a widely accepted business practice, with illegal usury reserved for interest rates exceeding the maximums set by law.

Interest and Inflation

Interest rates fluctuate constantly. They are controlled by supply and demand and other economic indicators. Other factors that help determine an interest rate include the length of the loan and any collateral used to secure the loan in the event the borrower cannot repay the loan. Low interest rates can stimulate the economy; consumers are attracted to low interest rates on consumer goods, cars, and houses and may spend more when interest rates are low. High interest rates usually have the opposite effect. Consumers are reluctant or unable to spend money, or spend as much money, when interest rates climb.

The Federal Reserve Board of Governors, part of the Federal Reserve System, sets a benchmark interest rate known as the prime rate. The Federal Reserve, the central bank of the United States, was founded in 1913 to help regulate the country's money supply. The goals of the Federal Reserve Board are to control inflation, maintain stable prices, and promote maximum employment and output of products for a favorable economy. This is done, in part, by raising and lowering interest rates. Low interest rates spur the economy but may lead to inflation, which harms the economy in the long term. The Federal Reserve Board looks at a range of economic indicators to help it determine what its policies should be and whether to raise, lower, or maintain the prime interest rate.

Any national bank must be a member of the Federal Reserve System and is governed by its fiscal policies. State banks may belong to the Federal Reserve System but are not required to; state agencies regulate state banks. Savings and loans, which are similar to banks in many ways, are regulated at the federal level by the Federal Home Loan Banks System. However, regardless of the Federal Reserve's jurisdiction over any financial entity, the prime interest rate is often the arbiter of interest rates.

Interest rates have a profound effect on the national and worldwide economies and are affected by economic changes as well. Economists like Adam Smith and David Ricardo theorized that interest rates are the key in balancing investments with savings. Marxist economists believe that interest benefits only capitalists, leaving other classes exploited, since no service is rendered to those who pay interest. Other economic theorists have deemed interest as a sort of reward for those who save, rather than spend, their money, since bank accounts and other investment vehicles typically pay interest to account holders.

State Usury Laws

ALABAMA: Legal rate of interest is 6 percent. Usury limit is 8 percent. Judgment rate is 12 percent.

ALASKA: Legal rate of interest is 10.5 percent. Usury limit is 5 percent above the Federal Reserve interest rate as of the date of the loan.

ARIZONA: Legal rate of interest is 10 percent.

ARKANSAS: Legal rate of interest is 6 percent. For consumers, the usury limit is 17 percent; for nonconsumers, the usury limit is 5 percent above the Federal Reserve interest rate. Judgment rate is 10 percent per annum or the lawful agreed upon rate, whichever is higher.

CALIFORNIA: Legal rate of interest is 10 percent for consumers. Usury limit is 5 percent above the Federal Reserve Bank of San Francisco rate.

COLORADO: Legal rate of interest is 8 percent. Usury limit is 45 percent. Maximum rates to consumers is 12 percent per annum.

CONNECTICUT: Legal rate of interest is 8 percent. Usury rate is 12 percent. Interest allowed in civil suits is 10 percent.

DELAWARE: Legal rate of interest is 5 percent over the Federal Reserve Rate.

DISTRICT OF COLUMBIA: Legal rate of interest is 6 percent. General usury limit is 24 percent.

FLORIDA: Legal rate of interest is 12 percent. General usury limit is 18 percent. For loans exceeding $500,000, the maximum rate is 25 percent.

GEORGIA: Legal rate of interest is 7 percent. Usury limit for loans less than $3,000 is 16 percent; otherwise 5 percent. For loans below $250,000, interest rate must be specified in writing and in simple interest.

HAWAII: Legal rate of interest is 10 percent. Usury limit for consumers is 12 percent.

IDAHO: Legal rate of interest is 12 percent. Judgment interest is 5 percent above U. S. Treasury Securities rate.

ILLINOIS: Legal rate of interest is 5 percent. General usury limit is 9 percent. Judgment rate is 9 percent.

INDIANA: Legal rate of interest is 10 percent. Judgment rate is 10 percent.

IOWA: Legal rate of interest is 10 percent. Maximum rate for consumer transactions is 12 percent.

KANSAS: Legal rate of interest is 10 percent. Usury limit is 15 percent. Judgment rate is 4 percent above federal discount rate. For consumer transactions, maximum rate of interest for first $1,000 is 18 percent; otherwise 14.45 percent.

KENTUCKY: Legal rate of interest is 8 percent. Usury limit is 4 percent above Federal Reserve rate or 19 percent, whichever is less. No limit for loans exceeding $15,000. Judgment rate is 12 percent compounded annually or at a rate set by the court.

LOUISIANA: Legal rate of interest 1 percent above average prime rate, not exceeding 14 percent or less than 7 percent. Usury limit is 12 percent.

MAINE: Legal rate of interest is 6 percent. Judgment rate is 15 percent for judgments below $30,000; otherwise the 52 week average discount rate for T-Bills plus 4 percent.

MARYLAND: Legal rate of interest is 6 percent. Usury limit is 24 percent. Judgment rate is 10 percent.

MASSACHUSETTS: Legal rate of interest is 6 percent. Usury limit is 20 percent. Judgment rate is 12 percent of 18 percent if the court finds a frivolous defense.

MICHIGAN: Legal rate of interest is 5 percent. Usury limit is 7 percent. Judgment rate is 1 percent above the five year T-note rate.

MINNESOTA: Legal rate of interest is 6 percent. Usury limit is 8 percent. Judgment rate is secondary market yield for one year T-Bills.

MISSISSIPPI: Legal rate of interest is 9 percent. Usury limit is 10 percent or 5 percent above the federal reserve rate. No usury limit on commercial loans exceeding $5,000. Judgment rate is 9 percent or legally agreed upon rate.

MISSOURI: Legal rate of interest is 9 percent. Judgment rate is 9 percent.

MONTANA: Legal rate of interest is 10 percent. General usury limit is 6 percent above New York City bank's prime rate. Judgment rate is 10 percent.

NEBRASKA: Legal rate of interest is 6 percent. Usury limit is 16 percent. Judgment rate is 1 percent above bond yield equivalent to T-Bill auction price.

NEVADA: Legal rate of interest is 12 percent. No usury limit.

NEW HAMPSHIRE: Legal rate of interest is 10 percent. No general usury limit.

NEW JERSEY: Legal rate of interest is 6 percent. Usury limit generally is 30 percent for individuals and 50 percent for corporations.

NEW MEXICO: Legal rate of interest is 15 percent. Judgment rate is determined by the court.

NEW YORK: Legal rate of interest is 9 percent. General usury limit is 16 percent.

NORTH CAROLINA: Legal rate of interest is 8 percent. General usury limit is 8 percent.

NORTH DAKOTA: Legal rate of interest is 6 percent. General usury limit is 5.5 percent above six-month treasury bill interest rate. Judgment rate is 12 percent.

OKLAHOMA: Legal rate of interest is 6 percent. Consumer loans may not exceed 10 percent unless lender is licensed; usury limit on non-consumer loans is 45 percent. Judgment rate is 4 percent above T-Bill rate.

OREGON: Legal rate of interest is 9 percent. Judgment rate is 9 percent or agreed upon rate, whichever is higher. Usury limit is 12 percent for loans less than $50,000.

PENNSYLVANIA: Legal rate of interest is 6 percent. General usury limit is 6 percent for loans less than $50,000. Criminal usury limit is 25 percent. Judgment rate is 6 percent.

PUERTO RICO: Legal rate of interest is 6 percent.

RHODE ISLAND: Legal rate of interest is 12 percent. Judgment rate is 12 percent. Usury limit is 21 percent or 9 percent above the interest rate charged for T-Bills.

SOUTH CAROLINA: Legal rate of interest is 8.75 percent. Judgment rate is 14 percent.

SOUTH DAKOTA: Legal rate of interest is 15 percent. Judgment rate is 12 percent.

TENNESSEE: Legal rate of interest is 10 percent. Judgment rate is 10 percent. General usury limit is 24 percent, or 4 percent above average prime rate, whichever is less.

TEXAS: Legal rate of interest is 6 percent. Judgment rate is 18 percent or contracted rate, whichever is less.

UTAH: Legal rate of interest is 10 percent. Judgment rate is 12 percent or contracted rate.

VERMONT: Legal rate of interest is 12 percent. Judgment rate is 12 percent. General usury limit is 12 percent.

VIRGINIA: Legal rate of interest is 8 percent. Judgment rate is 8 percent or contracted rate. No usury limit for corporation or business loans.

WASHINGTON: Legal rate of interest is 12 percent. General usury limit is 12 percent or 4 percent above average T-Bill rate, whichever is greater. Judgment rate is 12 percent or contracted rate, whichever is higher.

WEST VIRGINIA: Legal rate of interest is 6 percent.

WISCONSIN: Legal rate of interest is 5 percent. Judgment rate is 12 percent.

WYOMING: Legal rate of interest is 10 percent. Judgment rate is 10 percent or contracted rate, whichever is less.

Additional Resources

Lectric Law Library Lectric Law Library, 2002. Available at www.lectlaw.com.

West's Encyclopedia of American Law. West Group, 1998.

Organizations

American Bankers Association

1120 Connecticut Avenue, NW
Washington, DC 20036 USA
Phone: (800) 226-5377
URL: www.aba.com

bankrate.com

11811 U.S. Highway 1
North Palm Beach, FL 33408 USA
Phone: (561) 630-2400
URL: www.bankrate.com

United States Federal Reserve

20th Street and Constitution Avenue, NW
Washington, DC 20551 USA
Phone: (202) 452-3819
URL: www.federalreserve.gov

American Bankers Association

1120 Connecticut Avenue NW
Washington, DC 20036 USA
Phone: (800) 226-5377
URL: www.aba.com

bankrate.com

11811 U.S. Highway 1
North Palm Beach, FL 33408 USA
Phone: (561) 630-2400
URL: www.bankrate.com

INTEREST RATES

An interest rate is a standardized measure of either: (1) the cost of borrowing money or (2) the return for lending money for a specified period of time (usually one year), such as 12% annual percentage rate (APR).

First consider the term "interest" from the perspective of a borrower. In this case, "interest" is the difference between the amount of money borrowed and the amount of money repaid. Interest expense is incurred as a result of borrowing money. On the other hand, interest revenue is earned by lending money.

For example, the amount of interest expense, as a result of borrowing $1000 on January 1, 20XX, and repaying $1,120 on December 31, 20XX is $120 ($1,120–$1,000). The lender, on the other hand, received $1,120 on December 31, 20XX in exchange for lending $1,000 on January 1, 20XX, or a total of $120 in interest revenue. Thus, with regard to any particular lending event, interest revenue equals interest expense.

The formula used to calculate the amount of interest is:

interest = principal × interest rate × time [1]
where:
principal = amount of money borrowed
interest rate = percent paid or earned per year
time = number of years
Equation [1] can be rewritten as:
interest rate = interest ÷ principal [2]
where:
time = one year

The principal is also known as the present value. The interest rate in equation [2] is called the annual percentage rate or APR. APR is the most useful measure of interest rate. (In the remainder of this discussion, the term "interest rate" refers to the APR.)

Equations [1] and [2] are useful in situations that involve only one cash flow (a single-payment scenario). Many economic transactions, however, involve multiple cash flows. For instance, a consumer acquires a good or service and in exchange promises to make a series of payments to the supplier. This type of transaction describes an annuity. An annuity is a series of equally spaced payments of equal amount. The annuity formula is:

present value of annuity = annuity payment ¥ annuity factor_i,n [3]
where:
present value of annuity = value of the good or service received today (when the exchange transaction is finalized)
annuity payment = amount of the payment that is made each period

annuity factor = a number obtained from an ordinary annuity table that is determined by the interest rate (i ) and the number of annuity payments (n ).

An analysis of the effect of changes in interest rates requires controlling (or holding constant) two of the other three variables in equation [3].

The term "future cash flow(s)" describes cash that will be received in the future. Holding the number of payments and the amount of each payment constant, the present value of future cash flows is inversely related to the interest rate. Holding the number of payments and present value of the future cash flows constant, the amount of each payment is directly related to the interest rate. Holding the present value of the future cash flows and the amount of each payment constant, the number of payments is directly related to the interest rate. In summary, everything else held constant, increases in the interest rate (1) increase the amount of each payment, or (2) increase the number of payments required, or (3) decrease the present value of the future cash flows.

In order to understand the effect of changes in interest rates from a consumer's perspective, we first examine borrowing transactions in which the present value of the future cash flows and the number of payments are fixed. Consider, for instance, a thirty-year mortgage or a four-year auto loan. In each case, the effect of an increase in interest rates is an increase in the amount of the home or auto payment. This is shown in Table 1.

Well-known lending interest rates include the prime rate, the discount rate, and consumer rates for automobiles or mortgages. The discount rate is the rate that the Federal Reserve bank charges to banks and other financial institutions. This rate influences the rates these financial institutions then charge to their customers. The prime rate is the rate banks and large commercial institutions charge to lend money to their best customers. While the prime rate is not usually available to consumers, some consumer loans (such as mortgage lines of credit) are priced at "prime + 2 percent"; that is, a consumer will pay 2 percent over the prime rate to borrow money. When the Federal Reserve raises the discount rate, typically banks raise the prime rate and consumers pay higher interest rates.

Individuals lend money by investing in debt instruments, such as Treasury bills and bonds. In this scenario, the investor receives periodic payments (annuity payments) and a lump sum when the debt instrument matures. This stream of cash flows is valued as follows:

market value = annuity payment × annuity factor_i,n + maturity value × present value factor _i,n [4]
where:
market value = value of the debt instrument
annuity payment = amount of the payment that is made each period; it is equal to the interest rate stated on the debt instrument multiplied by the face value of the debt instrument
annuity factor = a number obtained from an ordinary annuity table that is determined by the interest rate (i ) and the number of annuity payments (n )
maturity value = amount received by the investor when the instrument matures, also known as the face value of the debt instrument
present value factor = a number obtained from a present value table that is determined by the interest rate (i ) and the number periods until maturity (n ).

When an investor purchases a debt instrument, the following factors are "fixed": (1) the amount of each annuity payment, (2) the amount of the maturity value, and (3) the number of periods until maturity (this is also the number of annuity payments that will be received in the future). As interest rates increase, the market value of the investment will decrease; that is, the price of debt securities is inversely related to the market rate of interest. This is shown in Table 2.

The investors who keep the investment until the debt instrument matures will receive the market rate of interest on their investment from the date of purchase. The investor who sells their investment prior to maturity will receive the market rate of interest on the investment until it is sold. At that time, this investor will also receive either a gain or a loss due to changes in the market value of this investment. If market interest rates decrease, the investor will receive a gain. If market interest rates increase, the investor will receive a loss on the value of the investment.

see also Finance; Investments

Henry H. Davis