“There’s no such thing as a free lunch.”
How many times have you heard that one? Although it has a cynical ring to it, when it comes to the world of finance and loans, it couldn’t be more true. Lending used to be so much easier – and free.
When farmers or villages suffered crop damage and natural disasters, wealthy land owners or feudal lords could bail them out if they needed to borrow money. It wasn’t ethically acceptable, for obvious reasons, to charge interest on loans which enabled your neighbors and workers to survive. To do so would have been usurious.
The Price You Pay to Borrow Money
Today, because societies realize the value of
investment for the future and for large public and private projects, lending has practical applications in every aspect of our modern world. Regardless of whether it’s for a credit card, loan, or line of credit, money lenders charge a price for allowing clients to borrow money and use their capital over a specific period of time.
This price is expressed as an interest rate. It’s a percentage because the cost is usually figured as a variable or fixed portion of the specific amount being credited, rather than a flat rate.
Primary rates, federal rates, mortgage rates, and many other interest rates are a part of daily life for millions of Americans. But do you really know what they are or what makes them move up and down? If want to own a car, home or even a
credit card you owe it to yourself to find out how these costs of borrowing are figured and how they affect you quality of life.
As mentioned above, the interest rate is your price of doing business with a lender. If you borrow money from a bank, for instance, you gradually repay your loan at set intervals. Usually a portion of each payment goes towards the interest and another portion towards the principle, or the actual amount borrowed. When someone says that they’re paying a mortgage, for instance, they’re referring to:
1. The amount of money per payment period that they’re paying to reduce the amount they owe on the principle of the loan
2. A percentage of the principle that goes to the lender to service the loan – the interest.
How is an Interest Rate Determined?
No matter what the interest rate is called, it will be set according to a number of factors:
- What institution is providing the credit
- The person, business, or institution receiving the credit
- How the funds will be used and the repayment financed
- How long the credit will be used (short-term rates and long-term rates can be very different)
- Whether the interest rate is fixed or will change over time (variable)
- The amount, frequency, and number of the payments
- Contractual guarantees and collateral (goods and/or services offered in case the borrower defaults on the credit repayment)
- Whether there’s a possibility of changing the parties of a contract or for altering the conditions of the contract
Higher Lender Risk Means Higher Interest Rates
Many of the above
restrictions have to do with the lender’s risk management. Generally speaking, if any aspect of the loan is perceived by a lender to be risky - and it could be anything from the future of the economy, to questionable collateral, to a borrower’s credit rating – the credit will be more expensive for the borrower. That’s because the interest rate will be higher to compensate the lender for the greater risk being taken on to provide the credit.
The main measure of your risk as a borrower in the eyes of a lender is
your credit report. There are other factors weighed as we mentioned, but this is numero uno when the lender evaluates you alone. If you’re good at
managing your own money more people trust you with theirs and it will cost you a lot less in the long run.