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.
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 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.