What borrowers pay and lenders earn
Editorial staff, J.P. Morgan Wealth Management
What is interest?
Interest is the cost of borrowing money.
When borrowing money, it is common practice to pay a fee to the lender. This fee is called interest. By paying interest, the borrower compensates the lender for loaning them the money. After all, the lender could have done something else with that money instead, and there is no guarantee they’ll get it back.
Interest is normally a percentage of the amount borrowed. For example, if you borrow $1,000 with a 2% interest rate, you will pay $20 in interest to the lender.
An interest rate on a given loan can be fixed, meaning it stays the same over the course of the loan, or variable, meaning it may rise or fall over time.
How interest impacts you
Chances are you’ve dealt with interest on at least a few occasions. Car loans, mortgages and credit cards are all types of borrowing that typically require interest payments. On the flip side, if you hold money in a savings account or have invested in bonds, you may be earning interest because you’re acting as a lender.
Interest works both ways, so depending on the type of transaction, you could be either the lender or the borrower. Here are two examples:
- Borrower: When you take on a mortgage, you agree to borrow a certain amount of money (called the loan’s “principal”) at a specific interest rate. Your monthly mortgage payment goes partially toward paying down your principal and partially toward paying interest on that principal.
- Lender: When you buy a bond, you are lending money to a company or government entity for its use. In return, it pays interest on the amount you loaned (in addition to returning that initial amount that you loaned it).
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What affects interest rates
What the interest rate is on a specific loan – such as whether it’s 2%, 20% or somewhere in between – depends both on the overall level of interest rates in the economy and on the details of that particular loan. Here are some specific factors that can affect interest rates:
- Federal Funds Rate: The Federal Reserve, the U.S. central bank, sets a target range for certain short-term interest rates. These interest rates influence other interest rates throughout the broader economy.
- Supply of money: The Federal Reserve also influences how much money is in circulation at any given time, which is known as the supply of money. Generally, when the supply is high, interest rates are lower because there is more money to loan. When the supply is low, interest rates tend to rise because there is less money to loan.
- Inflation: The value of a dollar, meaning how many goods or services a dollar can buy, may go up or down over time due to inflation. Lenders need to account for that change of value in the interest rates they charge. When expected inflation is higher, interest rates are typically higher. And lower expected inflation generally means interest rates are lower.
- Borrower risk: Loaning money can be risky, and lenders have to base their interest rates, in part, on the likelihood that the borrower will fail to repay the loan (called default). Lenders generally charge higher rates to higher-risk borrowers and lower rates to lower-risk borrowers.
- The rate on a specific loan can be influenced by the borrower’s:
- Credit score or repayment history
- Income
- Down payment size (such as on a home or car)
- Other outstanding loans
- It can also be influenced by whether or not the loan in question is secured, such as by a home or car that can be repossessed if the borrower defaults.
- The rate on a specific loan can be influenced by the borrower’s:
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Editorial staff, J.P. Morgan Wealth Management
