Interest Rate specifies the interest that a debtor has to pay their creditor for the borrowed money or that an investor receives for investing capital in a business. The interest rate is always given as a percentage and refers to a fixed period. A period of one year is usual. The period is usually indicated by the abbreviation “p. a. ” This abbreviation represents the Latin expression” per annum “and means by year.
Entrepreneurs who already write invoices can claim interest on late payment if the invoice recipient is in default on several occasions. You can read how to calculate default interest in our Billomat magazine.
What is the Economic Importance of the Interest Rate?
The level of the interest rate has a direct impact on business investment and consumer consumption. [b] The most important interest rate is the policy rate. [/ b] The European Central Bank (ECB) periodically reassesses the critical rate and adjusts it if necessary. The base rate directly impacts the interest rate that consumers and businesses pay on borrowed money. The lower the policy interest rate, the lower the interest rates on borrowed capital, increasing the willingness to borrow money for investment and private consumption.
The ECB’s key rates have been very low for several years. In other words, businesses and consumers who borrow today pay very little interest on the money borrowed. On the other hand, the so-called accurate interest rates that savers receive for their savings are meager. These real interest rates also depend on the ECB’s key rate. The so-called low-interest-rate policy aims to increase the willingness of businesses and consumers to invest so that the inflation rate in Europe reaches the target value of around 2% per year.
What Factors affect the Interest Rate on a Loan?
Interest rates determine the amount paid for a loan or that the investor will receive for an investment.
Banks take several factors into account when calculating interest rates on a loan. These factors are
- the ECB’s key rate
- the type of loan
- the duration of the loan
- the purpose of the loan
- the creditworthiness of the Borrower
The ECB’s Key Rate
Banks regularly use the critical rate of the European Central Bank (ECB) as an essential guide for the level of the lending rate.
The type of loan
Banks charge different interest rates depending on the type of loan. A short-term checking account loan usually has higher interest rates than, for example, a long-term loan for a home loan.
The Duration of the Loan
In principle, the longer the term of a loan, the greater the risk to the bank that the Borrower’s financial situation will deteriorate over time to the point that he can no longer repay the loan. Therefore, the interest rates on long-term loans are generally higher than those on short term loans.
The Purpose of the Loan
Banks grant loans for free use and specific purposes. Particular loans are, for example, home loans. Since with these loans, you know what the money is for and, for instance, with a car loan, the purchased vehicle serves as collateral; the interest rates are usually lower than for open-use loans.
Credit Rating of the Borrower
Creditworthiness is an important indicator for the lender to assess whether the Borrower will repay the loan or not. The higher the credit score, the safer the bank and the lower the interest rates.