Interest Rates Notes

Chapter 7: Interest Rates

Interest rates are crucial for economic activity, influencing borrowing costs, savings returns, and capital flow between countries.

• Impact exchange rates and global competitiveness.

• Essential for international business, affecting a country's attractiveness to investors, global pricing, and currency value.

What are Interest Rates?

• The cost of borrowing or the reward for saving money, as a percentage.

• Borrowing: Pay interest for using lender's money (home, car, personal loans).

• Saving: Earn interest for lending money to a bank (savings account, term deposit).

Why Pay Interest?

• It is the cost of money.

• Pays for using money not yet accumulated.

• Incentive for banks to lend and premium for risk.

• How lenders make a profit.

Practical Implications of Changing Interest Rates

• High Interest Rates

  • Philippine Peso gets stronger.

    • Attracts foreign investors seeking better returns on Philippine bonds and deposits.

    • Increased demand for pesos.

  • Encourages saving.

    • Banks offer higher interest on savings accounts and time deposits.

    • Motivates saving over spending.

  • Less disposable income.

    • More expensive loans (housing, car, credit cards).

    • Higher monthly payments.

  • Loan repayments increase.

    • New loans have higher interest, variable rates cost more.

  • Savings earn more interest.

    • Benefits savers as balances grow faster.

• Low Interest Rates

  • Philippine Peso weakens.

    • Less attractive assets for foreign investors.

    • Reduced demand for pesos.

  • Philippine exports are more affordable.

    • Supports exporters via weaker peso.

  • Encourages spending.

    • Promotes buying houses, cars, and business investments.

  • More disposable income.

    • Smaller loan repayments.

  • Loan repayments decrease.

    • Cheaper new and variable-rate loans.

  • Savings earn less interest.

    • Discourages saving.

How is Interest Calculated?

• Simple Interest: Percentage of initial amount only.

• Compound Interest: Calculated on entire balance, including previous interest.

Simple Interest

• Calculated only on the beginning principal.

• Example:

  • Year 1: 5% of 100 = $5 + $100 = $105

  • Year 2: 5% of 100 = $5 + $105 = $110

  • Year 3: 5% of 100 = $5 + $110 = $115

  • Year 4: 5% of 100 = $5 + $115 = $120

  • Year 5: 5% of 100 = $5 + $120 = $125

• Earned on term deposits.

Compound Interest

• Calculated on beginning principal and accumulated interest.

• Example:

  • Year 1: 5% of 100.00 = $5.00 + $100.00 = $105.00

  • Year 2: 5% of 105.00 = $5.25 + $105.00 = $110.25

  • Year 3: 5% of 110.25 = $5.51 + $110.25 = $115.76

  • Year 4: 5% of 115.76 = $5.79 + $115.76 = $121.55

  • Year 5: 5% of 121.55 = $6.08 + $121.55 = $127.63

• Earned on savings and bank accounts.

• Paid on credit cards, home loans, and car loans.

• Credit card interest compounds indefinitely.

Compound Interest Formula

• Formula: Pn = P0(1 + I)^n

  • P_n = Value at end of n time periods

  • P_0 = Beginning Value

  • I = Interest

  • n = Number of years

• Example:

  • 5% compounded interest on 100 for five years:

  • P_n = $100(1.05)^5

  • P_n = $127.63

Real vs Nominal Interest Rate

• Nominal Interest Rate: The stated rate before considering inflation.

• Real Interest Rate: The rate after considering inflation.

• Real Interest Rate = Nominal Interest Rate - Inflation Rate

Example

• Bank promises 5% nominal interest per year.

• Inflation this year is 3%.

• Nominal Interest: Earn 5,000, total balance 105,000.

• Real Interest: Real gain = 5% - 3% = 2% real interest.

Daily Life Example:

• Bank says: "We give 7% interest"

  • Nominal: 7%

  • If inflation is 5% this year

    • Real interest = 2%

• You borrow money at 10% loan interest

  • Nominal 10%

  • If inflation is 8%

    • Real cost of borrowing = 2%
      Meaning: If inflation is high, even if you earn or pay a lot nominally, the real value is much smaller!

Types of Interest Rates

• Fixed Interest Rates

  • Set percentage for the life of the loan or account.

  • Easier budgeting (e.g., home loan).

  • Important to shop around.

• Variable Interest Rates

  • Varies depending on market and rates (LIBOR, BSP).

  • Provider may raise or lower rates.

  • Vulnerable to unfavorable market changes.

  • Chance to benefit from favorable shifts.

Factors That Affect Interest Rate

• Credit history is important.

• Economic factors shift over time.

• Factors out of your control:

  • Supply and demand:

    • Increase in demand for money or decrease in supply raises rates.

    • Decrease in demand or increase in supply lowers rates.

  • Inflation:

    • Rising prices decrease purchasing power.

    • Benefits those carrying debt, lowers value of each dollar owed.