Question

Now that you have a better understanding of interest rates, consider a situation in which you need to purchase a car for work. You have found a reliable car within your budget, but you are not sure whether or not to finance the purchase. What questions would you need to consider before making such a decision? What are some of the pros and cons of using credit?

Your journal entry must be at least 200 words in length. No references or citations are necessary.

Answer 1

What Is an Interest Rate?

The interest rate is the amount a lender charges for the use of assets expressed as a percentage of the principal. The interest rate is typically noted on an annual basis known as the annual percentage rate (APR). The assets borrowed could include cash, consumer goods, or large assets such as a vehicle or building.

Understanding Interest Rates

Interest is essentially a rental or leasing charge to the borrower for the use of an asset. In the case of a large asset, such as a vehicle or building, the lease rate may serve as the interest rate. When the borrower is considered to be low risk by the lender, the borrower will usually be charged a lower interest rate. If the borrower is considered high risk, the interest rate that they are charged will be higher. Risk is typically assessed when a lender looks at a potential borrower's credit score, which is why it's important to have an excellent one if you want to qualify for the best loans.

For loans, the interest rate is applied to the principal, which is the amount of the loan. The interest rate is the cost of debt for the borrower and the rate of return for the lender.

When Are Interest Rates Applied?

Interest rates apply to most lending or borrowing transactions. Individuals borrow money to purchase homes, fund projects, launch or fund businesses, or pay for college tuition. Businesses take loans to fund capital projects and expand their operations by purchasing fixed and long-term assets such as land, buildings, and machinery. Borrowed money is repaid either in a lump sum by a pre-determined date or in periodic installments.

The money to be repaid is usually more than the borrowed amount since lenders require compensation for the loss of use of the money during the loan period. The lender could have invested the funds during that period instead of providing a loan, which would have generated income from the asset. The difference between the total repayment sum and the original loan is the interest charged. The interest charged is applied to the principal amount.

Advantages of Interest Rates

Interest rates hold advantages for both borrowers and lenders. Fixed interest rates are attractive to borrowers who want to know exactly what each of their loan payments will be, without regard to market fluctuations. If interest rates rise, the borrower who has a fixed-rate mortgage is locked into the lower interest over the life of the loan instead of having to pay the higher interest rate of newer loans. If interest rates decrease, lenders have the advantage by making more money from their customers with higher-interest rate loans.

Mortgage loans with an adjustable interest rate often help would-be homeowners buy a house and begin repaying their loan at a lower interest rate. Even though the interest rate may increase on ARM loans, it typically doesn’t adjust until after the first year of payments. By then, new homeowners may have paid down other debt so that they can better manage their higher mortgage payments.

Although simple interest is a source of unearned income, investors like to earn compound interest. Compared side by side on an equal investment amount, compound interest earns the investor more money than simple interest.

Disadvantages of Interest Rates

The advantage of a particular interest rate for some people may also be disadvantageous to others if there’s a significant change in the economy. The same low interest rate that lures borrowers can drive away potential investors because of a low return on their investments.

When interest rates rise, existing borrowers with lower-interest loans have the advantage. But potential borrowers are at a disadvantage in this environment because high interest rates may drive up the amount of their monthly mortgage payments, for example, beyond the threshold they can afford. This also puts many lenders in a lurch if they don’t have a large-enough borrowing pool from which they're earning interest. Business owners often have to raise the prices of their goods and services when interest rates rise so they can cover the cost of their business loans, which makes the overarching effect of high interest rates disadvantageous for consumers.