Interest rates are the payments one makes to another as the cost of borrowing funds. Interest rates should be equal to different borrowers under the same prevailing economic conditions. Various factors come into play to determine the interest rate to be paid by a borrower. This paper explores the factors used in determining the prevailing interest rates. Among the factors used to determine interest rates are credit quality, local and world economic and political conditions (Lando 143).
In addition, the demand and supply of funds also determine the interest rates set on borrowings. The borrower always has a feeling that the interests charged are the best deal and that better returns will accrue from the funds borrowed. In the same manner, the lender should also feel the interest charged would have the best returns. Credit quality refers to the capability of investors to pay under a given economic situation. Interest rates are charged in direct proportionality to credit quality (Singleton et al 56).
Big businesses and government can easily pay for the loans borrowed plus the interests charged. An investor may also compare the opportunity cost of money over a given period. The economic condition may be in a state of either inflation or deflation, forcing the lender to consider the opportunity cost of funds over a given period. An increase in inflation rate results in an increased rate since the expected inflation rate is also accounted for in the rates set (Sullivan et al 505-506).
For instance, if in a situation without inflation, the interest rate is 4%, then this becomes 7% if the inflation rate is 3%. The declining value of collateral due to inflation may affect a borrower’s ability to pay. This will increase the risks associated with the repayment ability of the borrower. The higher risks are therefore included in the interest rate charged. Political subsidies by governments also influence interest rates.
Governments can lower the interest rates on borrowers by subsidizing certain loans such as college student loans, public housing loans, and other public work program loans. Conclusion Interest rates, the excess on a borrowed money paid to the lender by the borrower, is determined by many factors. The main factor is the prevailing economic conditions. These could be inflation or deflation. The government may also subsidize certain type of borrowers to motivate them to borrow. The ability of the borrower to pay, the credit quality, is also a vital determinant of interest rates.