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.
Related or Semi-related Video
Finance: How Are Interest Rates Determin...674 Views
Finance a la shmoop how are interest rates determined? mm-hmm...so imagine
this some nice stranger out there just pre-approved you for a credit card [Person thinking about credit cards]
groovy looking over the paperwork you got in the mail however it appears
there's a 20% interest rate attached awesome ish except you have no idea what
an interest rate is why it's that percentage or who set it at 20% well
congratulations you're about as clueless as the typical 35 year old these days [Woman walks into lamp post holding credit card]
but here's the lowdown for every thousand bucks you borrow on that credit
card you'll be paying two hundred bucks a year to rent that money and you'll
continue to pay that every year until both the principal and the interest of
your loan are paid off well there are two elements to an interest rate one [Elements to interest rate appear]
element is the economy the world's interest rates are generally set by
governments seeking to either add fuel to the flame of the economy by lowering
rates and making money cheap to borrow so people spend and hire people or they're
trying to suck oxygen from its thirsty gaping maw so that the world's economies
are relatively stable and inflation is under control meaning they make the cost
of borrowing money high so the pricing doesn't get out of control and that's
for a different video and we'll get to that later...when economies are weak
the government lowers interest rates right they're hoping to encourage people
to spend money greenlight new projects hire new bodies [People shaking hands]
do stuff with their dough low interest rates on credit cards are generally a
good thing for consumers seeking to buy tchotchkes like earrings and belly rings
at a mall so that is if your credit card only charged you 2% a year in interest [Interest of credit card formula appears]
well that'd be 20 bucks a year to rent that grand and with cheap money
available to you well you'd be happy to buy more belly rings on credit well
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 generally
to old people which sucks because we love the [Old man falls over]
guys they always have butterscotch candy take for example someone who lives on a
pension that pays them say 3% a year like it's all in bonds because they have
to be safe they can't take stock market risk so they only get 3%
well if inflation skyrockets and it's 10% a year well in a very short time
period they're spending dollar buys only half as much as it used to and while
then you can find these people living in a station wagon from the 70s parked on [Old man and woman sitting on chairs]
your local curb got it so if inflation is 10% they're only getting 3 they're
losing 7 percent of their buying power every year so that was the capital
markets price of money I.e what's the price the government
sets for the cost of its best customers to borrow money yeah that's the Fed
that's kind of how they price lending money to banks all right well who are
the best customers Google, Bill Gates that nun who just won the lottery [Nun appears in church]
but that doesn't tell the whole interest rate story here why would you be charged
20% interest on your credit card and Bill Gates only 3% one word risk if
you're Bill Gates who's got like roughly a bajillion dollars and you're taking a [Bill Gates relaxing in a chair]
loan for a short duration and have a long history of paying back your debt
well you're a low risk to pay back that thousand dollars bill borrowed to put
his bellybutton ring in at the mall and a bank can afford to charge him a small
interest rate because it's so likely they'll get paid back whereas if you're
just some bum named Gil Yates no relation obviously and you have five [Gil standing at a bus stop]
dollars to your name and are a huge flight risk well a bank is probably not
going to be too excited to offer you any loan at all and if they did it would
feature an extremely high interest rate to make up for the risk of you not
paying them back right if you were the bank you'd probably do the same thing
so who's the magic wizard behind the curtain who sets these things in the [Interest rate appears from out of magicians hat]
first place and how does that work well financially the US is still the center
of the world the Fed is the American vehicle which
sets the price to banks for borrowing money the Fed, the Fed yeah it sounds
kind of kind of like big shot there right well structurally banks might pay
1% to the government to borrow money and then they might mark up the price of
that money to 5% make 4% spread between the bid and the ask
price of the debt that they basically buy from the government and then resell
to people like you and me... in English you bet say a bank takes a million dollar
loan from the Fed it'll pay $10,000 a year in interest to the Fed for [Interest payment calculation appears]
borrowing that money if it turns around and loans money to Joe the Plumber
a million dollars for his parts distribution business charging him 5%
per year well then Joe pays the bank 50 grand a
year to rent that money and the bank shows a gross profit thereof $40,000 a
year just for kindly Joe that's 50 minus 10 you know some heavy calculus there
now while all of this might sound like the financial gravy train is not that [Gravy train of money goes by]
simple Joe the plumbers business well like that kind of business goes bankrupt
all the time and when that happens banks don't get paid back the million bucks
they loaned Joe sometimes they get zero the banks are however still on the hook
for the million dollars they borrowed from the American federal system if the
bank doesn't pay back the Fed well they basically all go to jail and get
tortured in Guantanamo or something like that oh wait we don't torture anymore do
we oh we do all right then well then you
don't want to default on the Fed so anyway that widespread of 4% has to cover
a lot of deadbeats who don't follow through on their promises to pay back
the money they borrow that's how it works in the US and most Western [Western countries highlighted on map]
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 percent
annual rate and it takes you ten years to pay off that money well your total
interest would be and strap yourself in there here's the math it's ten thousand
times the quantity one plus 0.2 which is the 20% there to the tenth power that's
how you do the math there so what's 1.2 to the 10th which reflects the
compounding of that interest rate for about ten years well it's about 6.2
how do you get the math well you multiply that number by 10,000 which
revealed that a 20% interest rate on a 10-grand loan for 10 years cost you
about 62,000 big ones 10 grand it really cost you 62... [Bill gates appears]
compare that to Bill Gates who can spend $10,000 on a cheap card costing 3% and
doesn't pay it back for 10 years well here's the difference the cost of
renting that 10 grand for 10 years at 3% well it's about 1.35 and yes Bill's
cost of renting that doe for 10 years 13.5 grand vastly cheaper because
well Bill is a vastly safer bet to pay back his debt than you are as for that [Interest rates for Bill and Joe appear]
20% rate on your new credit card well it sounds steep but it's sadly pretty
average just be sure to pay it off each month because if you get way behind in
your payments well, the magic wizard behind the curtain isn't going to swoop
in to save you sorry just keeping it real