You need to borrow money for your various needs ranging from medical needs to purchasing a car, from buying a house to renovating the existing one, from setting up a start-up to expanding your running business. But we know that Borrowing money comes at a cost. You take money for a certain specified period after the expiry of which you not only have to return the capital but also the interest incurred on your principal amount. In such a circumstance it is the interest rate that matters. Then what is the first and foremost thing you must consider while borrowing money? Undoubtedly, it is the rate of interest. In other words, you have to pay to ‘hire’ someone else’s money. Certainly, you will want to borrow money at lower interest rates. Conversely, most of us are happy when we get more interest payments from the bank on our savings. So, in either case, the level of interest rates plays an important role in deciding which bank or financial institution to opt for.

As we know, an interest rate is a percentage of the total amount that you pay when you borrow or you get when you save in banks. In the case of your saving, you will look for lenders which pay you more interest, and on the contrary, if you are a borrower, you will search for a lender which will let you borrow money at lower interest rates.

Factors influencing the interest rates

In most of the European countries, the monetary policy and consequently the interest rates are set keeping in mind the inflation target of 2% to hit. But that’s not the only thing you should look for, you should also consider the factors which support the economy and objectives of the government for growth and employment. Now, you cannot please everyone with one interest rate as “the one size fits all” principle does not apply here. If interest rates are low borrowers are happy but savers are not and vice versa when interest rates are high. The key is to balance the two in the interest of the overall growth of the economy of any country.

The factors influencing the interest rates are:

• the government’s policy and directives
• the currency of the capital amount sum borrowed or lent
• the maturity period of the loan
• the capital amount and the currency
• supply and demand in the market
• the amount of collateral and many more.

Reasons for changing interest rates

These are the reasons why interest rates are changed:

• Political short-term gain: often when elections are around the government lowers the interest to give the economy a short-run boost for influencing the election results. Privatization of the banking system can reduce the impact of politics on rates of interest.
• Delayed consumption: Sometimes the borrowed money is transferred to the borrower’s account but the borrower is unable to spend it or use it according to the pre-decided schedule at the time of borrowing then in that case in a free market there will be a positive interest rate.
• Inflationary expectations: Inflation is inevitable in the economy. Simply, it implies that the buying capacity of individuals decreases over time. Hence, the borrower needs to pay off the lender for the inflation factor.
• Alternative Investments: The lender sometimes prefers to put the extra amount of borrowed money into different investment plans to compensate for the interest rate he needs to pay off to the lender.
• Risks of investment: The lender needs to safeguard his money from the risk of the borrower getting bankrupt or otherwise default in loan repayment due to death or absconding, to compensate for this a lender usually charges a risk premium.
• Liquidity preference: People prefer liquidity in their investment so they can realize their money immediately in case of need rather than waiting for it.
• Taxes: As per the existing tax law in most countries, some of the gains from the interest incur taxes, so the lender may demand a higher rate to compensate for this loss.
• Banks: Lowering or raising the interest rate by the banks has a remarkable impact on the economic growth of any country. The interest rates are raised to slow down the economy where'as interest rates are lowered to boost economic growth.
• Economy: Interest rates can vary according to the economic status of the country, the stronger the economy, the higher the interest rate and vice versa.
• Impact on savings/pensions: Low-interest rates may, sometimes, adversely affect the funding positions of ‘pension funds’ if they are not optimized to combat the effect of inflation.

Impact of lowering the interest rates

• Lower interest rates encourage consumers to spend more i.e., they may be inclined to buy more and hence borrow more, which shoots demand for everyday goods. This benefits the lenders as they can lend more.
• Mortgages are considered secured loans so they have the lowest interest rates of all loans. Fixed-rate mortgages are preferred over variable-rate loans by home buyers.
• Lowering interest rates boosts economic growth as people participate more actively in borrowing and investing.
• Now the question arises if the interest rates are lower how the banking sector makes a profit. Banks hold cash in abundance, which they invest in short-term investment tools, thereby compensating for their pay-outs as an interest to customers.
• The lower the interest rates, the higher the unemployment, because in that case companies prefer to hire low-paid temporary or part-time workers instead of expensive ones. This lowers the buying capacity of employees, leading to a decline in the industrial and economic development of the country, thereby further increasing unemployment.
• If interest rates are low, bonds, especially government bonds, become a less attractive investment tool. Still, it is preferred by individuals who prefer risk-free investment.
• Lower interest rates, however, encourage additional investment spending, which stimulates the economy in times of recession. The role of the FED is to adjust the interest rates in sync with the demand and supply scenario.