What is the interest rate?

The interest rate is the cost of money: the price we pay to use funds we do not have and must repay (a loan), or the return we receive when we choose not to spend our money immediately, by investing or lending it. Interest is expressed as a percentage of the amount moved over time and on an annual basis.

Example

If we take out a loan of 100 euros at an annual rate of 5 per cent, after one year we must repay the original 100 euros plus 5 euros in interest.

What determines the interest rate?

The interest rate can be seen as the result of several components:

  1. Real interest rate: this represents the basic return on capital and is determined by the balance between the supply of savings and the demand for investment, i.e. how much households save and how much firms and the government invest. This balance depends mainly on economic growth, productivity, preferences for present consumption, and demographic factors.
  2. Compensation for expected inflation: this protects the purchasing power of money over time.
  3. Risk premium: this depends on how reliable the borrower is and on the length of the loan.

These elements together determine the rates we observe in practice.

Expected Inflation

Interest rates tend to be higher when expected inflation is higher.

Example

Suppose that today 100 euros allow us to buy 100 packs of pasta at one euro each, and that expected inflation is 2 per cent. After a year, we expect to buy only 98 packs with the same amount (each costing 1 euro and 2 cents). We would therefore be willing to lend our money for a year only if we are compensated - at least partly - for the loss caused by inflation.

Duration

The longer the duration of the loan (or investment), the greater the uncertainty about the future. As a result, the compensation required (or offered) tends to be higher. For example, the annual rate for a 30‑year loan is usually higher than that for a 10‑year loan.

Example

Suppose we want to lend 100 euros for two years and can choose between:

• lending 100 euros at 5 per cent for one year, and then deciding whether to renew for another year;

or

• lending 100 euros at 5 per cent per year for two years.

The first option is less risky because it allows us to earn the same return while keeping the flexibility to stop after one year. If we give up this flexibility and commit our money for a longer period from the start, we ask for higher compensation.

Creditworthiness

The interest rate is higher when the borrower's reliability, also known as creditworthiness, is lower, which means that there is a greater risk that they will not repay the capital and interest.

Example

Company Alfa is very reliable, while Company Beta has a high risk of default. If both companies offer us an interest rate of 5 per cent, we would only be willing to lend to Alfa. To consider lending to Beta, we would require a higher interest rate to compensate for the greater risk.

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