What is Interest?
It’s been a while since my last post, and I wanted to take a chance to get back to the roots of investing by explaining what interest is and how it works. This is one of the most crucial component to know before any investment.
This is how Wikipedia describes interest;
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money,or money earned by deposited funds.
I like to simply explain it in this way; Interest is the cost/reward of borrowing/lending money.
Here are some things that pays an interest:
[checklist]
- Bonds (Including T-bills)
- Savings Accounts
- Certificate of Deposits
[/checklist]
How does interest work?
What you hear on the TV or read in the news is the Federal Funds rate, this is the rate which banks can lend from the Federal Reserve for a short period of time. There’s a big difference between the Federal Funds Rate and what your Savings rate is. The Fed’s rate is always lower than what the bank charge you for a mortgage or another type of loan. Why? You might ask, and the answer is simple, risk. The reason you see different interest rates has to do with risk.This applies to a lot more than just interest rates, where an investor want to get bigger return for a riskier investment.
Let’s say that you have two friends, David and Andreas, who want to borrow $100 from you. David has paid you back 9 out of 10 times and Andreas has paid you back 7 out of 10 times. If they both pay you back $110, you would go for David. However, if Andreas says that he pays you back $120 or $150 you might go for Andreas instead.
This is how it works in the real world and that’s why you have a credit score, it measures how big the chance is that you repay your debt.
How interest rates can hurt you
[Credit: MoneyRates.com]
As always, there are two sides of the coin. If you’re on the other side, as an investor, you’ll benefit from the compounding interest.
Here is how compounding interest helps you
[Credit: Bankrate.com]
Why is then interest rate an important number to look at before one invest?
An investor looks at the riks-free rate in order to determine opportunity cost of making an investment.
If you can put your money in a risk-free investment yielding 5% instead of a stock with low growth and only 3% dividend yield, you might do that. However, when the risk-free rate is closer to 1%, as it is today, the 3% dividend and potential capital gain of a stock looks pretty good.
By looking at the current Federal Funds Rate and what the savings and loans rate is, we can easier understand the estimated risk vs. reward of an investment, and avoid overestimating risk. This is why people don’t want the Federal reserve to increase their funds rate as the opportunity cost of other investments will go up, and the price of their stocks will go down.
