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Regardless of whether rates are generally high or low,
some rates are higher than others.
The interest rate that you pay on a car loan typically
is higher than the interest rate that you receive on
an account in a savings bank, for example, and the interest
rate on a credit-card balance is higher than the rate
on a new-car loan.
Several major factors explain these rate differences:
risk, duration, tax considerations, and other characteristics
of a loan. |
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One risk that a lender faces is that of not being repaid.
The greater the chance that you won’t be repaid, the higher
the interest rate you will have to charge as compensation
for taking the risk. On the other hand, if a loan involves
little risk, you would be willing to accept a lower interest
rate. That’s why the federal government can borrow at
lower rates than can private parties. People are sure
the government will pay its debts.
To see how much lower the interest rate is on
government borrowing than on borrowing by a corporation,
see: Interest
Rates 
and examine the chart titled, "Long-Term Interest
Rates." |
Some lenders reduce the risk of losing what they have
lent by requiring the borrower to pledge collateral,
property that the lender can take possession of if the
borrower doesn’t repay the loan. The risk is smaller
in such "secured" loans than in unsecured
loans, so the interest rates are lower, too. Auto loans,
for example, carry lower rates than credit-card loans,
because the lender can take possession of the car if
the borrower fails to pay.
When you apply for a loan, you often have to fill out
a form on which you provide information that the lender
can use to determine how likely you are to be able to
repay the loan. Similarly, there are business firms
that rate the creditworthiness of individuals, other
firms, and even governments; lenders use this information
to determine what rates to charge on loans. |
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The longer the duration of a loan, the more likely the
lender is to desire access to the funds. So lenders typically
have to be compensated with higher interest rates for
parting with their funds for longer periods.
The longer the duration of a loan, the greater the
uncertainty over whether the borrower will be able to
repay the loan. So, lenders have to be compensated for
the greater risk with higher interest rates on longer-term
loans.
Inflation is a major factor determining the
level of interest rates. The longer the duration of
the loan, the greater the risk that inflation can accelerate,
reducing the purchasing power of the loan repayment.
So, rates generally are higher on long-term loans than
on short-term loans, because people who lend for longer
periods have to be compensated for the risk that inflation
might accelerate during the longer periods.
| A "yield curve" shows how interest rates
vary by the duration of a loan. |
| Short-term rates occasionally are higher than
long-term rates. When that happens, economists worry
about a possible recession, or a downturn in the
economy. For a discussion of the meaning of such
an "inverted yield curve," see: Current
Issues of Economics and Finance .
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If you receive interest income, you are more concerned
with how much of the income you can keep than with how
much the borrower pays. You are concerned with after-tax
income -- that is, the interest you receive minus any
taxes you have to pay on that interest.
Interest on some types of loans has some tax advantages.
Interest on loans to state and local governments is
exempt from the federal income tax, and interest on
loans to the federal government (such as the interest
you receive on U.S. Savings Bonds) is exempt from state
and local income taxes. These tax advantages help governments
borrow at lower interest rates than individuals or businesses. |
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When you put money into a bank account, you are allowing
the bank to use the money. There are different types of
bank accounts, though, and they pay different rates of
interest. An account that allows you to write checks,
for example, provides you with a benefit, so it pays a
lower rate than a savings account, which does not offer
this benefit.
If you agree to leave your funds in a savings account
for a specified time – two years or five years, for
example – you are providing the bank with some benefits.
The bank knows for certain that it will keep your deposit,
and it knows it can use the funds longer than if you
had deposited them in, say, a checking account. In return,
the bank will pay you a higher rate than on an account
from which you can withdraw your funds at any time.
Suppose you lend to someone and suddenly you need the
money back. It would be advantageous to you to be able
to convert the loan into money quickly and without losing
much of what you have lent. Loans that can be converted
into money quickly and without a loss (either because
you can demand that the borrower repay the loan at any
time or because you can sell the loan to someone else)
carry lower rates than other loans.
For a more detailed discussion of how interest
rates are determined, see: "Points
of Interest," 
published by the Federal Reserve Bank of Chicago. |
| There are some differences in interest rates that
not atttributable to any of the reasons we have
discussed. Just as some stores charge higher prices
than other stores for the same items, some lenders
charge higher rates than other lenders. In other
words, while competition eliminates some price differences
between similar goods and some interest-rate differences
on similar loans, it doesn't eliminate all of them.
So, if you are going to borrow, it might be a good
idea to "shop around" to learn what interest
rates different lenders charge. For a useful guide
to credit card use, see: Shop
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Banks charge higher interest rates on the loans
they make than they pay on deposits. They do that
in order to make a profit. So, why can't people
cut out the bank as an intermediary and do the lending
themselves, at the higher rates? There are several
reasons:
- As an individual, you may not be able to find
anyone who wants to borrow the amount you want
to lend. Banks, though, can combine many people's
funds to lend borrowers the amounts they want
to borrow
- As an individual, you may not be able to find
anyone who wants to borrow for precisely the
amount of time you want to lend. Banks. though,
always have new deposits coming in, so they
can lend for as long a period as people want
to borrow for
- Banks are much better than individuals at
determining which potential borrowers are likely
to repay loans, and which aren't
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