The Cost of Borrowing Money
Interest and fees charged on a loan have the effect of increasing the cost of an object or service purchased with credit. Various methods which are used to calculate interest rates can mislead a borrower about the actual cost of a loan. The interest rate that you pay to borrow money is influenced by numerous factors relating to the type of loan that you choose. The length of time over which a loan is to be repaid, the collateral, your credit history, and the lender that you select are all important aspects of the interest rate that you’ll be charged. However, rates are also influenced by factors outside the control of both the borrower and lender and unrelated to the specifics of a particular loan. Here are some of the key influences that go into determining the interest rate that you’ll pay:
- Economic conditions have an important influence on overall interest rates. Rates tend to increase during periods of strong economic activity when the demand for credit is high. A vital and healthy economy causes businesses to borrow funds in order to expand their output. At the same time, high employment rates and wage increases which accompany economic expansion usually make consumers more optimistic, leading them to buy more goods and services on credit. This increased demand for credit results in higher prices paid, in the form of interest rates, for that credit.
On the other hand, a weak economy does little to stimulate demand for credit by businesses or consumers. Industries operating at less-than-capacity along with rising unemployment cause cautiousness and cutbacks in spending and borrowing. The light demand for credit during these periods tends to drive interest rates downward.
- The inflationary expectations of consumers and businesses can have a major impact on interest rates. Lenders who foresee rising prices for goods and services will charge higher interest rates in order to compensate for the likelihood that their loans will be repaid with devalued dollars. At the same time potential borrowers, who are also anticipating rising inflation rates, are more likely to accept higher-interest loans because they expect to be able to pay them back with devalued dollars. The anticipation of rising inflation also stimulates consumers and businesses to buy as soon as possible in order to beat the expected price increases, placing more of a demand on credit which, in turn, drives interest rates upward.
- Policies and actions of the federal government can also be a major influence on interest rates. Large federal deficits that occur when expenditures exceed tax revenues require the government to annually borrow tens or hundreds of billions of dollars, which causes tremendous strains on the credit markets by taking lendable funds away from businesses and consumers. This increases the demand for credit and exerts upward pressure on interest rates.
