In any given market, money is lent out in several forms at an interest rate meant to compensate the lender for the amount of money and length of time borrowed. If observed side-by-side, similar loans from among different lenders will frequently bear similar interest rates. The general interest rate level for a given type of loan across numerous lenders is known as the prevailing interest rate.
How They Work
An interest rate is a numerical percentage which is multiplied, usually on an annual basis, by the amount of money borrowed and determines the lender's compensation (i.e., it is the price of money). Simple interest is calculated by multiplying the interest rate only by the amount originally borrowed, or principal amount. This means that periodic interest amounts will always be the same. Compound interest multiplies the interest rate by the principal amount plus all interest accrued up to that point. As a result, compound interest accrues more quickly than simple interest. Compound interest typically applies to credit cards.
Any transaction between two parties wherein one party borrows money from the other involves an interest rate. From a consumer's standpoint, such items as mortgages, academic loans and lines of credit require that the consumer pay interest to the lending bank for use of the borrowed funds. Debt securities, such as bonds, savings accounts and short-term money market securities (commercial paper), also constitute loans from an institutional standpoint because the consumers who purchase them are lending money to the issuing entities.
Prevailing interest rates are determined on the basis of the bank rates established by a country's central banking authority (in the U.S., the Federal Reserve). Bank rates are the effective rate at which a central bank lends money to commercial banks within its own market, or country. Smaller commercial banks then lend money to consumers and companies at a similar, but slightly higher, rate to allow a profit margin. A central bank sets bank rates in accordance with its own goals for fostering stable economic growth. This involves, but is not limited to, staving off price inflation and maintaining stability of its currency in the foreign exchange market.
Determining Prevailing Rates
Based on bank rates, prevailing interest rates are effectively determined by the economic climate at any given time. During a period of stable economic growth, or expansion, prevailing interest rates rise in response to a commensurate rise in bank rates. Such a rise is the result of greater demand for loans as companies seek to expand. In other words, the "prices" of loans rises with increased demand, similar to the prices of goods and services. By contrast, a sustained decline in economic growth, or recession, impels central banks to reduce bank rates, as companies seek to ease up on growing due to economic uncertainty.
Since commercial banks disburse loans at an interest rate based on local bank rates, all variations in the interest rates charged by commercial banks must be greater than the applicable bank rate. The risk of a given loan is reflected in the difference between the loan's interest rate and the prevailing interest rate for similar loans. The closer the interest rate is to the prevailing interest rate, the more creditworthy the borrower. Conversely, a loan with an interest rate which is significantly higher than the prevailing interest rate indicates higher risk of non-payment on the part of the borrower.