If you are getting a loan, or have a credit card, or have money in a bank account, or partake in any number of other financial activities, you have seen the term interest rate thrown around. Interest rates are one of the most important financial concepts, and understanding where they come from is important to your financial future.
Risk Free Rate
Investors generally consider government debt to be “risk free.” Greece, Spain, and Ireland are recent examples of that not being the case all the time, but countries like the United States and Germany are considered financially stable. As such, a loan to that government is risk free.
In the United States, the risk free rate is pegged to Treasury Bills, often called T-Bills. You can see the T-Bill yield curve at the Treasury website. In Europe, German government bonds are most commonly used as the debt free rate.
Interbank Rates
At the end of the day, some banks need funds to fulfill their obligations. Other banks have extra cash. The Federal Reserve has developed a system for overnight, interbank loans. Those loans are made at the Fed Funds rate. When you hear that the Federal Reserve board made a change to interest rates, this is the rate they are referring to.
This rate is important to consumers because it is a driver of the interest rates you pay on a loan. You always pay more than the interbank rate. If the Fed raises or lowers the interbank rate, your rate will change as well.
In much of the world, LIBOR is used as the interbank rate. LIBOR is the London Interbank Offer Rate. It is used internationally as a benchmark rate for many floating rate investments.
Prime Rate
Prime is the interest rate a bank gives to its best customers when it makes a loan. Most major banks choose their own prime rate, though some regional banks look to larger banks for their prime rate.
Floating rate business loans are often quoted as “Prime plus ___,” where the ___ is an interest rate added on for risk. A small business might get a loan at prime plus 5% where a large business might get a loan at prime plus 1%. That is because the small business has a higher risk of default than the large business.
Your Interest Rate
At the end of the day, this is the rate that really matters to you. Your investments and loans all come with an interest rate. That rate compounds over time. This is a very powerful concept. As Albert Einstein once said, “compound interest is the most powerful force in the Universe.”
Questions? Hit me in the comments.
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Awesome post! Great job explaining various rates! Having a good credit ensures you get a good rate, now that I'm shopping for a home, I'm experiencing first hand how this helps!
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Good luck house hunting. I used to write mortgage loans for a bank, so let me know if you have any questions.
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The interest we pay is indicative how responsible we are with money. The interest we earn is indicative of the risk we are willing to take. Thanks for the information.
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Glad you like the post.
So do you think interest rates will see any significant increase this year? We are considering a refinance to move to a 15 year mortgage. Thoughts?
I think they are going to go up a little bit, but nothing too dramatic in 2011. As the economy gets going again, rates will slowly increase as well.
Hi Eric,
great post and information. I can't thank you enough for this great resource of a site you offer and your willingness to share your knowledge with everyone. I've used plenty of advice you've given over the past year since I've found your site and my finances have done a complete 180! I'm now on top of everything with Mint, my cc's are less than $500 total and my credit report is finally cleared up. 2 yrs ago my score was 515… as of today I just applied for a loan to pay off some outstanding debts and I received my score of 721!!
thanks for your advice, knowledge, help, time, effort, etc..!!!!
Great job on the turnaround. Keep it up and come back often. If you ever have specific questions, let me know through the comment form.
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