Interest Rate

So imagine this: Some nice stranger out there just pre-approved you for a credit card. Groovy. Looking over the paperwork you got in the mail, however, it appears there’s a 20% interest rate attached. Awesome. Except that you have no idea what an interest rate is, why it’s that percentage, or who set it.

Congratulations. You’re about as clueless as the typical 35-year-old.

But here’s the low-down: for every thousand dollars you borrow, you’ll be paying $200 per year to rent that money, and you’ll continue to pay every month until both the principal and the interest of your loan are paid off.

There are two elements to an interest rate. One element is the economy. The world’s interest rates are generally set by governments seeking to either add fuel to the flame or suck oxygen from its thirsty, gaping maw...so that the world’s economies are relatively stable. When economies are weak, the government lowers interest rates, hoping to encourage people to spend money. Low interest rates on credit cards are generally a good thing for consumers seeking to buy tchotchkes. That is, if your credit card only charged you 2%, then per thousand dollars, it only costs you $20 a month to rent that money.

Things work in the opposite direction as well. When economies get too hot and inflation runs out of control, governments seek to cool things down by raising the cost of money. When inflation is very high, bad things happen to old people. Which sucks, because we love those guys. They always have candy.

Take, for example, someone who lives on a pension that pays them 3% a year. If inflation is 10% per year, in a very short time period, their spending dollar buys only half as much as it used to, and then you can find these people living in a station wagon from the 70s, parked on your local curb.

So that was the capital market’s price of money? What's the price the government sets for the cost of its best customers to borrow money? Well, who are the best customers?

Google "Bill Gates."

Or that nun who just won the lottery.

But that doesn’t tell the whole interest rate story. Why would you be charged 20% interest on your credit card and Bill Gates only pays 3%? One word: risk. If you’re Bill Gates, who’s worth roughly a bazillion dollars, and you’re taking a loan for a short duration and have a long history of paying back your debts, you’re a low risk, and a bank can afford to charge you a small interest rate.

But if you’re just some bum named Gill Yates (no relation, obviously), and you have five dollars to your name and are a huge flight risk, a bank is, well...they’re probably not going to offer you a loan at all. But if they did, it would feature an uber-high interest rate.

So who’s the magic wizard behind the curtain who sets these things in the first place, and how does that work? Well…financially, the United States is still the center of the world. The Fed is the American vehicle which sets the price to banks for borrowing money. Structurally, banks might pay 1% to borrow money, and then lend money at 5%, making a 4% spread between the bid and the ask price of the debt that they “resell.”

In English? You bet.

Say a bank takes a million dollar loan from the Fed. It will pay $10,000 a year in interest. If it turns around and loans money to Joe the Plumber, a million dollars for his parts distribution business, charging him 5% per year, then Joe pays the bank $50,000 a year to rent that money. And the bank shows a profit of $40,000 per year.

That's 50 minus 10. Some heavy calculus there.

Now, while all of this might sound like the financial gravy train, it’s not that simple. Joe the Plumber’s businesses go bankrupt all the time, and when that happens, banks don’t get paid back the million bucks they loaned him. The banks are, however, still on the hook for the million dollars they borrowed from the American federal system.

So that wide spread of 4% has to cover a lot of deadbeats, who don’t follow through on their promises to pay back the money they borrowed. That’s how it works in the U.S., and most Western countries have more or less the same system. The numbers may seem small to you, but over time they really add up.

If you borrow 10,000 at a 20% annual rate, and it took you 10 years to pay it off, what would your total interest would be? Here’s the math: Ii's ten thousand times the quantity 1 plus point two (which is the 20 percent) to the 10th power. So what’s 1.2 to the 10th, which reflects the compounding of that interest rate for 10 years? About 6.2. So you multiply that number by 10,000, which reveals that a 20% interest rate on 10 grand for 10 years costs you about 62 thousand big ones. Compare that to Bill Gates, who can spend $10,000 on a cheap card costing 3% and doesn’t pay it back in 10 years.

Here’s the difference…the cost of renting the 10 grand for 10 years at 3 percent? About 1.35. And yes, Bill’s cost of renting that dough for 10 years? $13.5k.

Vastly cheaper because, well, Bill is a vastly safer bet to pay back his debts than you are. As for that 20% rate on your new credit card...it sounds steep, but it’s pretty average. Just be sure to pay it off each month, 'cause if you get way behind on payments, the magic wizard behind the curtain isn’t going to swoop in and save you.