Market prices are determined by supply and demand. One important factor that influences the supply and demand of the market is the interest rate. Simply put, interest rates are fees charged by lenders, which are a percentage of the total amount of money lent or borrowed. In this article, you will learn how interest rates work and their impact on business.
What is the meaning of interest rate?
Every time a loan is issued, the borrower pays the lender a percentage of the total loan. This percentage is known as the interest rate.
Interest rate is the cost of borrowing or the reward for lending money.
Suppose you issue a bank loan of 100 at a 5% interest rate. The cost of borrowing money is 5. This 5 will be paid to the lender at the end of the period as a reward for lending.
There are many types of loans with different interest rates and lending periods. For example, credit cards give cardholders the money to pay for goods and services with the promise to pay them back at a later date, usually once per month. If the payment is not made on time, the cardholder will be charged a very high interest rate. Mortgages are long-term loans on housing that can be paid back over a long time.
The interest rate that all banks charge borrowers is called the base rate. In the UK, the current base rate is stable at 0.5%. A low base rate encourages people to borrow more and spend on goods and services, which results in economic growth.
Types of interest rates
Interests can be calculated as simple interest or compound interest.
Figure 1. Types of interest rates, StudySmarter
Simple interest
The easiest and quickest way to calculate interest is simple interest.
Simple interest is charged on the initial principal at a given rate over a given period of time.
Here's the formula:
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Where:
A is the total amount after n years
P is the initial principal
r is the interest rate
t is the number of periods
Paul borrows £10,000 from a bank and agrees to pay interest at the end of each calendar. Suppose the term of the loan is 10 years and the interest rate is 5%, his interest payment will be:
£10,000 x 5% X 10 = £5,000
Compound interest
Compound interest is the more complex form of interest.
Compound interest is calculated with accumulated interest added to the principal. The interest of the first year is added to the initial principal, the interest of the second year is calculated on the initial principal plus the first-year interest.
Here's the formula:
Where:
A is the total amount after n years
P is the initial principal
r is the interest rate
n is the number of periods
Max opens a savings account of £10,000 at an interest rate of 5% for 10 years. Suppose during the investment period, Max did not withdraw any money. The interest of each year is added to the previous year, and the compound interest he will earn at the end of the period is:£10,000 x (1+0.05)10 - £10,000 = £6,470.09
In the case of a loan, the amount of interest you pay each month will be lower since it is calculated on the initial loan value minus the amount you’ve already paid.
Here’s the formula for calculating the repayment of a loan for each period:
Where:
A is the amount payable per period
P is the initial principal (loan)
r is the interest rate
n is the number of periods.
Anna takes out a £10,000 loan and promises to pay it back in 5 years (60 months). Calculate Anna’s monthly repayment and the cost of borrowing when:
a) the interest rate is 7%
b) the interest rate is 5%.
a) Anna’s monthly payment is £198.01. The total amount paid is £198.01 x 60 months = £11,880.6. Thus, the cost of borrowing is £1,880.6.
b) Anna’s monthly payment would be £188.71. The total amount paid is 11,322.6 and the cost of borrowing is £1,322.6.
From the above examples, the lower interest rate is more beneficial to Anna as it costs less to borrow money.
Effects of interest rates on businesses
An increase in interest rates means that the cost of borrowing is rising whereas a fall in the interest rate indicates a lower cost of borrowing.
When interest rates are high, people pay more for debts, leaving them with less money to spend on goods and services. This reduces consumer spending and causes business revenues to drop. Decreasing interest rates will have the opposite effect. (See Figure 2).
Figure 2. Effects of interest rate on business, StudySmarter
Not all businesses are affected the same by changes in the interest rate. Higher interest rates will cause people to spend more on budget products while cutting down on luxury and durable products such as cars or houses. When interest rates are high, businesses will also refrain from borrowing money for investment and growth. Thus, companies supplying machinery or buildings for businesses will experience a fall in sales.
Impact of low interest rates on business
With lower interest rates:
The cost of borrowing decreases. Individuals and businesses are incentivised to borrow money for spending or investment.
Debt payments are lower. This leaves people with more money to spend on goods and services and increases consumption.
Higher consumption results in more revenues for businesses, which increases their output and demand for labour.
Impact of high interest rates on business
With higher interest rates:
The cost of borrowing increases. Individuals and businesses will refrain from borrowing money.
Debt payments are higher. This leaves people with less money to spend on other goods and services and results in lower consumption.
Lower consumption reduces business revenues, which leads to decreasing output and demand for labour.
Interest rate impact on international businesses
Higher interest rates attract foreign investors to invest in one country, as they can make more money than when investing in other countries. The demand and value of the home country’s currency rises, thereby boosting the economy. Businesses also receive more funds to cover their financial needs.
On the other hand, when interest rates are low, foreign investors will have less incentive to invest in their home country. This results in a fall in the demand and value of its currency, thus causing the economy to shrink. Businesses will have a hard time attracting foreign funds for growth and expansion.
Impact of a change in interest rates on lenders and borrowers
Generally, a change in interest rates has opposite effects on borrowers and savers (See Table 1).
| Lenders | Borrowers |
Increase in interest rates | Higher reward for lending. People are likely to lend their money. | Higher cost of borrowing. People are discouraged from borrowing money. |
Decrease in interest rates | Lower reward for lending. People are discouraged from lending their money. | Lower cost of borrowing. People are more likely to borrow money. |
Table 1. Changes in interest rates and their effects on savers and borrowers, StudySmarter
To lenders and borrowers, interest rates can mean different things. For savers, interest rates are rewards for lending. With higher interest rates, they will be incentivised to lend their money. For borrowers, interest rates are the costs of borrowing. When interest rates are high, they will be discouraged from borrowing.
Effects of interest rates on businesses - Key takeaways
The interest rate is the cost of borrowing money or the reward for lending it out.
There are two main types of interest rates: simple interest rates and compound interest rates.
An increase in interest rates means that the cost of borrowing is higher, whereas a fall in the interest rate reflects a reduced cost of borrowing money.
Higher interest rates reduce consumer spending and business investment, causing the economy to contract.
Lower interest rates encourage consumer spending and business investment, resulting in a more burgeoning economy.
Savers and borrowers experience opposite effects when the interest rates rise or fall. Increasing interest rates are more beneficial to savers, as they can earn more from the saved money. However, borrowers will have to pay a higher cost for loans.
References
Sarah Guershon, "Bank of England base rate". bankrate.com. 2022
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