Interest Rates
The payment borrowers make for the use of the funds that they borrow and the payment that lenders demand for the use of the funds they lend (termed interest) which is expressed as a percentage of the principal (loan amount). This percentage is known as interest rate. Interest rates typically are expressed in overall percentages and basis points. A basis point is one hundredth of a percentage point. There are basically four main parts to market interest rates:
- The risk (or default) premium
- The maturity premium
- An inflation premium
- The "real" rate
The risk premium is identifying that several classes of borrowers have greater or lesser risk by default. Interest rates are higher for riskier borrowers because they are lowest for the U.S. Treasury, which is considered as a "risk-free" borrower. The difference in interest rate among any other borrower and the U.S. Treasury for the similar maturity is called a quality spread. The maturity premium reflects the fact that, in general, a longer loan will have a higher interest rate compare to a shorter loan of the similar quality. The yield curve shows the change in interest rates as maturities are extended for a given class of loans. The inflation premium is identifying that inflation may erode the purchasing power of the funds lent. Therefore, interest includes compensation for the inflation expected over the length of the loan. The remaining part of interest rates reflects the real rate of interest that must be paid to induce the lender to forego the use of the funds. (Note that this is not simply the interest rate less present inflation, but rather interest rates less the average expected inflation over the length of the loan. Subtracting the present inflation rate gives an inflation-adjusted interest rate. Often, since the future interest rates will be assumed to conform to an average of past rates and lenders use some such average as a proxy for expected inflation.)