Interest Rates and Their Effects

High inflation is detrimental to lenders because the money they receive back is worth less than what they originally lent. To compensate, lenders increase interest rates.

The federal funds rate (or BSP Rate in the Philippines) is the interest rate financial institutions charge each other for short-term loans.
The U.S. Federal Reserve uses the federal funds rate to influence the economy:
- Lowering the rate encourages borrowing during economic slowdowns.
- Raising the rate discourages borrowing when the economy grows too fast to curb inflation.
The federal funds rate serves as a baseline for the prime rate, which is the interest rate banks offer to their most creditworthy customers.
As the federal funds rate increases, other interest rates tend to increase as well.

The primary goal for lenders is to minimize risk. Borrowers can secure better interest rates by making themselves less risky.

Credit scores reflect creditworthiness. Lenders assess credit scores and history to determine lending risk.
High credit scores indicate a strong ability to repay debts, resulting in lower risk for lenders.
Low credit scores suggest a higher risk of default, leading to higher interest rates or loan rejection.
Credit scores can be improved, and services exist to help repair credit.

Larger loan amounts and longer repayment terms increase interest rates due to the increased risk for the lender.
Larger loan amounts mean higher monthly payments.
Longer repayment terms increase vulnerability to inflation and life events that could impact repayment ability (though fixed-rate loans are immune to inflation).
Before borrowing, borrowers should assess the necessary loan amount and strive for the shortest realistic repayment period.

A guarantee is an agreement to settle a debt in an alternate way if the borrower defaults.
Guarantees can include collateral, cosigners, or a personal guarantee.
Adding a guarantee can reduce interest rates by lowering the lender's risk.
Borrowers should carefully review guarantee agreements due to potentially unusual terms.
Some loans, like auto loans (which use the vehicle as collateral), have mandatory guarantees.

High-interest rates on personal loans, home loans, and car loans reduce customers' disposable income, which can decrease sales for businesses.
Low-interest rates leave customers with more cash to spend, benefiting businesses.

High-interest rates encourage businesses to invest excess cash in interest-bearing accounts.
Low-interest rates may prompt businesses to invest in new equipment and plant improvements.
Banks benefit from business investments that boost assets, allowing them to make more loans.

If banks cannot earn reasonably high interest rates, they become less likely to take risks on loans, which can hinder start-ups, expansions, and innovation.
Short-term loans for cash flow can be difficult to obtain, potentially disrupting the delivery of goods and services.

While low-interest rates are typically desired to stimulate the economy, they can also have negative effects.
The Federal Reserve lowers interest rate targets to encourage borrowing and spending during recessions.
Low rates increase the money supply, supporting economic recovery up to a point.

When savings accounts and certificates of deposit (CDs) offer unattractive returns, people may pay down debt or invest in goods, services, or assets, reducing bank deposits.
Insurance companies may increase premiums due to lower interest-based returns on premiums.
Low-interest rates negatively impact individuals who rely on interest income, leading to decreased spending.
Decreased spending by large groups like retirees can slow overall economic activity.

Negative interest rates occur when a central bank sets interest rates below zero during severe economic downturns.
In a negative interest rate environment, borrowers are paid to borrow money, while savers are penalized. This is intended to stimulate borrowing and lending.
Depositors must pay to keep their money in the bank, incentivizing banks to lend money and businesses/individuals to invest and spend it.
Negative interest rates are intended to combat deflationary periods where people hoard money, leading to decreased demand, falling prices, reduced production, and increased unemployment.
Loose or expansionary monetary policy is used to address economic stagnation; however, if deflationary forces are strong, cutting the central bank's interest rate to zero may not be sufficient.

Negative interest rates are considered a last-resort effort to boost economic growth when traditional policies have failed.
Theoretically, negative interest rates reduce borrowing costs for companies and households, encouraging investment, consumer spending, and demand for loans.
Retail banks may absorb the costs of negative interest rates rather than passing them on to small depositors to avoid deposit withdrawals.

An example of NIRP is setting the key rate at -0.2 percent, where bank depositors pay two-tenths of a percent on their deposits instead of receiving interest.
- Switzerland used negative interest rates in the early 1970s to counter currency appreciation.
- Sweden (2009, 2010) and Denmark (2012) used negative interest rates to stem hot money flows.
- The European Central Bank (ECB) instituted negative interest rates in 2014 to prevent the Eurozone from deflation.
Fears of moving money into cash (M1) did not materialize, but evidence suggests negative interest rates in Europe reduced interbank loans.

The overnight rate is the interest rate large banks use for borrowing and lending in the overnight market.
In some countries, the central bank targets the overnight rate to influence monetary policy.
The central bank participates in the overnight lending market, lending or borrowing money to banks.
The overnight rate is the interest rate banks charge each other on loans for meeting reserve requirements.
It's frequently confused with the discount rate, which is the interest rate central banks charge on loans, but they are different rates.

Banks receive income from loans; they ideally want to loan out as much as possible.
To prevent bank failure during a "run on the bank," the Federal Reserve uses a fractional reserve banking system.
The fractional reserve banking system requires banks to keep a percentage of their deposits liquid to accommodate normal withdrawals.
If a bank cannot meet reserve requirements, it can obtain a Federal Funds loan, which is unsecured and short-term (typically overnight).

An increase in the overnight rate discourages banks from borrowing to meet reserve requirements, encouraging them to retain more reserves and lend less money.
A reduction in the overnight rate encourages banks to borrow to meet reserve requirements, making more money available for lending.
Changes in the overnight rate can alter the economy by putting upward or downward pressure on interest rates.