What is Interest and how does it Actually Work?
TL;DR, it's a little more complicated (interesting?) than it initially appears.
First, money you receive today is worth more than money in the future. The economic term for this is the Time Value of Money. This is because time itself is considered to have value in the world of finance.
The Time Value of Money is the reason why interest is charged on loans, which is also sometimes called the Discount rate. In simple terms, interest is the opportunity cost of a creditor (someone who is loaning out money) to give away their money. If you had $100 that you wanted to spend on a vacation that your friend also wanted, how much extra would they have to offer to convince you to loan it to them? Banks ask this same question every day.
The interest you would pay on a bank loan is called the Real Rate of Interest. For a bank, it is the total amount extra that you have to give them for them to be willing to give you the loan.
The Real Rate of Interest is the sum of four separate values that financiers use to figure out the Total Cost of Risk.
First, the Inflation Premium asks how much the value of a unit of currency (U.S Dollar, Euro, etc.) is going to change over time. Inflation naturally erodes the value of money. $1 becomes $0.95 after a year of 5% inflation.
Second, the Default Risk Premium is the cost of the risk to the bank that you will default (basically saying that you can’t and won’t pay back your loan). In this case, they lost their entire investment net of any payments you have already made. This premium will be different for everyone, unique to their employment situation, level of education, job type, and dozens of other factors that will be discussed in a later edition.
Third, the Liquidity Risk Premium asks the question of what it would cost to seize the asset (whatever you bought with the loan money) and turn it into cash. This changes depending on exactly what you are buying. Downtown Toronto or New York City real estate will have a lower premium than Buffalo real estate because properties in the former cities are easier to sell quickly on the market.
Fourth, the Maturity Premium recognizes that for infinite reasons, a longer-term investment is naturally more risky. The longer your money is loaned, the greater the statistical likelihood that something will happen (war, famine, other acts of god, your own random chance of death) to prevent you from enjoying your money as an investor again in the future.
These are the four conditions that go into calculating the rate of interest you pay on loans. In some cases, this will be different, such as with government student loans, but these principles cover most cases.
There are two ways to calculate the future value (FV) of your money when you lend it out.
Simple interest: If you have money in a bank account that pays a 5% rate of interest, $100 will become $105 after one year.
Compounding interest: If you keep that deposit in the bank for a second year untouched, you now earn interest on your $105, which works out to $110.25.
The principle of compounding return is incredibly important to understand. It is the way many people invest their way to a wealthy future.
Suppose you start with $1000. If, for a period of 25 years, you put that in a high-interest bank account that pays 2.5%, you will end up with $1853. Not great, seeing as the target rate of inflation in both Canada and the U.S. is 2%.
Now, suppose you put that same $1000 into a mutual fund that returns 3.85% a year net of MER (see this post for a quick primer on different passive investment vehicles) over the same 25-year period. You would end up with $2571, assuming you leave it alone (though this isn't exactly advisable given the inherent market risk).
Alternatively, assume you hold a stock with a nice dividend of 1.5% paid quarterly (6% over the year). Watch closely, that same $1000 invested in that stock (assuming the price never changes) and with all the dividends reinvested, would return $4432.04. This is because instead of compounding only once per year as in the previous examples, this dividend compounds four times. The more often an amount compounds, the faster it will grow even if the rate remains unchanged.
I hope you’ve enjoyed this quick primer on interest rates!
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Sincerely,
James R. Davies