What Are Interest Rates?

man looking at illustration of interest rate percentage
DNY59/E+/Getty Images

Like anything else in economics, there are a few competing definitions of the term interest rate. The Economics Glossary defines interest rate as:

"The interest rate is the yearly price charged by a lender to a borrower in order for the borrower to obtain a loan. This is usually expressed as a percentage of the total amount loaned."

Simple Versus Compound Interest

Interest rates may be implemented either as simple interest or via compounding.

 With simple interest, only the original principal earns interest and the earned interest is set aside.  With compounding, on the other hand, the earned interest is combined with the principal so that the amount that earns interest grows over time.  Therefore, for a given base interest rate, compounding will result in a large effective interest rate than will simple interest.  Similarly, more frequent compounding (the limiting case being known as "continuous compounding") will result in a higher effective interest rate.

Interest Rate or Interest Rates?

In day to day conversation, we tend to hear references to "the interest rate". This is somewhat misleading, as in an economy there are dozens if not hundreds of rates interest between borrowers and lenders. The differences in rates can be due to the duration of the loan or the perceived riskiness of the borrower. To learn more about the different types of interest rates, see What's the Difference Between all the Interest Rates in the Newspaper?

Nominal Interest Rates vs. Real Interest Rates

Note that when people discuss interest rates, they're generally talking about nominal interest rates. A nominal variable, such as a nominal interest rate, is one where the effects of inflation have not been accounted for. Changes in the nominal interest rate often move with changes in the inflation rate, as lenders not only have to be compensated for delaying their consumption, they also must be compensated for the fact that a dollar will not buy as much a year from now as it does today.

Real interest rates are interest rates where inflation has been accounted for. This is explained in more detail in Calculating and Understanding Real Interest Rates.

How Low Can Interest Rates Go?

Theoretically, nominal interest rates could be negative, which would imply that lenders would pay borrowers for the privilege of lending money to them. In practice, this is unlikely to happen, but on occasion, we do see real interest rates (that is, interest rates adjusted for inflation) go below zero. To learn more, see: What Happens if Interest Rates Go To Zero?

Format
mla apa chicago
Your Citation
Moffatt, Mike. "What Are Interest Rates?" ThoughtCo, Apr. 1, 2017, thoughtco.com/interest-rates-economics-definition-1146349. Moffatt, Mike. (2017, April 1). What Are Interest Rates? Retrieved from https://www.thoughtco.com/interest-rates-economics-definition-1146349 Moffatt, Mike. "What Are Interest Rates?" ThoughtCo. https://www.thoughtco.com/interest-rates-economics-definition-1146349 (accessed December 11, 2017).