Don't Let Interest Rates Fool You
Albert Einstein has referred to interest as the eighth wonder of
the world, the greates invention of the human race, and the most
powerful force in the universe.
Why is this so? Interest has three major functions in finance.
It is the surcharge placed on the repayment of borrowed money or
goods; it is the return which is derived from investments; and
interest also refers to a person's right or claim to a
corporation, such as that of a creditor or owner.
In economics, interest is referred to as rent on money. Rent, or
economic rent, is further defined as a payment to a factor of
production (land, labor, and capital goods).
Like any other form of rental, interest rates constantly change
to reflect market conditions. Interest rate is the percentage by
which balances grow, and the initial balance is referred to as
the principal. Interest rates have remarkable effects on finance
and economics, thus, they are the most watched market indicators.
History suggests that the Sumerian civilization is the first to
have developed a structural credit system based on grain and
silver, the two main commodities. Before the advent of coins,
Sumerians practiced a credit system where loans were made in the
form of metals based on their weights.
Loans of grain and silver made trading possible. Silver was used
by towns, and the country economies used grain.
As proof to this historical claim, archaeologists have uncovered
metal pieces believed to be used in trade in Troy, Minoan, and
Mycenaean civilizations. They have also found similar items in
Babylonia, Assyria, Egypt, and Persia.
Today, credit has changed into an entirely new system. Banks,
individuals, and other financing institutions have developed
their own system of collecting interest for the repayment of
borrowed money, or debt.
This practice; however, is considered usury by religious orders
such as the Jewish and Christian. In Islam, a special type of
banking is practiced, which is consistent with Islamic laws,
such that the collection and repayment of interest is
prohibited. There are Islamic banks which cater to this specific
banking system.
Interest accumulates in two ways: by growing linearly with time
(simple interest), and by growing exponentially over time
(compound interest). Simple interest, the method by which
interest accumulate linearly with time, is seldom practiced
because the interest earned by the money previously is assumed
to have remained in the account.
When this happens, the amount of money which is subject to
interest increases because the previous interest remained with
the capital money.
With compound interest, outstanding balances, which may include
the principal and other add-on amounts, balance grow
exponentially through time. This means that periodically, the
total balance grows by percentages of the total of the principal
and the interest paid in previous periods.
In this mode of interest, the rate of compounding influences the
whole amount of interest which is paid over the duration of the
loan. The growth function in compound interest is an exponential
function with regards to time.
Today, there are two general types of interest rates for debt
instruments. Debt instruments are also called income streams,
which pertains to the stream of income for the person who lends
money.
There are a number of debt instruments such as business-based,
collateral-based, consumer-based, contingency-based,
government-based, and insurance-based instruments. These
interest rates are fixed-rate and variable rate.
Fixed-rate instruments, the more common between the two, have
fixed value throughout the instrument's duration. This interest
rate is usually used in bonds.
Variable-rate instruments are typically attached to an index
which floats according to the economic conditions such as prime
rate (interest rate given by lenders to customers who are
considered trustworthy) and CPI or consumer price index
(statistical measure of the average of prices of a set of
economic goods and services bought by wage earners in urban
areas).