Editing Interest (section)

==Market interest rates==
{{Unreferenced section|date=January 2009}}
There are markets for investments (which include the money market, bond market, as well as retail financial institutions like banks) that set [[interest rate]]s. Each specific debt takes into account the following factors in determining its interest rate:

===Opportunity cost and deferred consumption===
[[Opportunity cost]] encompasses any other use to which the money could be put, including lending to others, investing elsewhere, holding cash, or spending the funds.

Charging interest equal to inflation preserves the lender's purchasing power, but does not compensate for the [[time value of money]] in [[real versus nominal value (economics)|real terms]]. The lender may prefer to invest in another product rather than consume. The return they might obtain from competing investments is a factor in determining the interest rate they demand.

===Inflation===
Since the lender is deferring consumption, they will ''wish'', as a bare minimum, to recover enough to pay the increased cost of goods due to [[inflation]]. Because future inflation is unknown, there are three ways this might be achieved:
* Charge X% interest "plus inflation" Many governments issue "real-return" or "inflation indexed" bonds. The principal amount or the interest payments are continually increased by the rate of inflation. See the discussion at [[real interest rate]].
* Decide on the "expected" inflation rate. This still leaves the lender exposed to the risk of "unexpected" inflation.
* Allow the interest rate to be periodically changed. While a "fixed interest rate" remains the same throughout the life of the debt, "variable" or "floating" rates can be reset. There are derivative products that allow for hedging and swaps between the two.

However interest rates are set by the market, and it happens frequently that they are insufficient to compensate for inflation: for example at times of high inflation during, for example, the oil crisis; and during 2011 when real yields on many inflation-linked government stocks are negative.

===Default===
There is always the risk the borrower will become [[bankrupt]], [[Theft|abscond]] or otherwise [[Default (finance)|default]] on the loan. The [[risk premium]] attempts to measure the integrity of the borrower, the risk of his enterprise succeeding and the security of any collateral pledged. For example, loans to developing countries have higher risk premiums than those to the US government due to the difference in creditworthiness. An operating line of credit to a business will have a higher rate than a [[mortgage loan]].

The [[creditworthiness]] of businesses is measured by [[credit rating agency|bond rating service]]s and individual's [[credit score]]s by [[credit bureau]]s. The risks of an individual debt may have a large standard deviation of possibilities. The lender may want to cover his maximum risk, but lenders with portfolios of debt can lower the risk premium to cover just the most probable outcome.

===Composition of interest rates===
In economics, interest is considered the price of credit, therefore, it is also subject to distortions due to [[inflation]]. The nominal interest rate, which refers to the price before adjustment to inflation, is the one visible to the consumer (that is, the interest tagged in a loan contract, credit card statement, etc.). Nominal interest is composed of the [[real interest rate]] plus inflation, among other factors. An approximate formula for the nominal interest is:

:<math> i= r + \pi </math>

Where
:''i'' is the nominal interest rate
:''r'' is the real interest rate
:and {{pi}} is inflation.

{{see also|Fisher equation}}

However, not all borrowers and lenders have access to the same interest rate, even if they are subject to the same inflation. Furthermore, expectations of future inflation vary, so a forward-looking interest rate cannot depend on a single real interest rate plus a single expected rate of inflation.

Interest rates also depend on [[credit risk|credit quality or risk of default]]. [[government debt|Governments]] are normally highly reliable [[debtor]]s, and the interest rate on government securities is normally lower than the interest rate available to other borrowers.

The equation:

: <math> i = r + \pi + c </math>

relates expectations of inflation and credit risk to nominal and expected real interest rates, over the life of a loan, where
:''i'' is the nominal interest applied
:''r'' is the real interest expected
:{{pi}} is the inflation expected and
:''c'' is [[yield spread]] according to the perceived credit risk.

===Default interest===
Default interest is the rate of interest that a borrower must pay after material breach of a loan covenant.

The default interest is usually much higher than the original interest rate since it is reflecting the aggravation in the financial risk of the borrower. Default interest compensates the lender for the added risk.

From the borrower's perspective, this means failure to make their regular payment for one or two payment periods or failure to pay taxes or insurance premiums for the loan collateral will lead to substantially higher interest for the entire remaining term of the loan.

Banks tend to add default interest to the loan agreements in order to separate between different scenarios.

In some jurisdictions, default interest clauses are unenforceable as against public policy.

===Term===
Shorter terms often have less risk of default and exposure to inflation because the near future is easier to predict. In these circumstances, short-term interest rates are lower than longer-term interest rates (an upward sloping [[yield curve]]).

===Government intervention===
Interest rates are generally determined by the market, but government intervention - usually by a [[central bank]] - may strongly influence short-term interest rates, and is one of the main tools of [[monetary policy]]. The central bank offers to borrow (or lend) large quantities of money at a rate which they determine (sometimes this is money that they have created ''ex nihilo'', that is, printed) which has a major influence on supply and demand and hence on market interest rates.

===Open market operations in the United States===
[[Image:Federal funds effective rate 1954 to present.svg|thumb|right|375px|The effective federal funds rate charted over more than fifty years{{Citation needed|date=November 2011}}]]
The [[Federal Reserve]] (Fed) implements monetary policy largely by targeting the [[federal funds rate]]. This is the rate that banks charge each other for overnight loans of [[federal funds]]. Federal funds are the reserves held by banks at the Fed.

[[Open market operations]] are one tool within monetary policy implemented by the Federal Reserve to steer short-term interest rates. Using the power to buy and sell treasury [[Security (finance)|securities]], the Open Market Desk at the [[Federal Reserve Bank of New York]] can supply the market with dollars by purchasing [[United States Treasury security#Treasury note|U.S. Treasury notes]], hence increasing the nation's money supply. By increasing the money supply or [[Aggregate Supply of Funding]] (ASF), interest rates will fall due to the excess of dollars banks will end up with in their reserves. [[Excess reserves]] may be lent in the [[Federal funds|Fed funds]] market to other banks, thus driving down rates.

===Interest rates and credit risk===
It is increasingly recognized that during the business cycle, [[interest rate]]s and [[credit risk]] are tightly interrelated. The [[Jarrow-Turnbull model]] was the first model of credit risk that explicitly had random interest rates at its core. Lando (2004), [[Darrell Duffie]] and Singleton (2003), and van Deventer and Imai (2003) discuss interest rates when the issuer of the interest-bearing instrument can default.

===Money and inflation===
Loans and bonds have some of the characteristics of money and are included in the broad money supply.

National governments (provided, of course, that the country has retained its own currency) can influence interest rates and thus the supply and demand for such loans, thus altering the total of loans and bonds issued. Generally speaking, a higher real interest rate reduces the broad money supply.

Through the [[quantity theory of money]], increases in the money supply lead to inflation. This means that interest rates can affect inflation in the future.<ref>{{Cite web|date=2009-06-23|title=What's the Relationship Between Inflation and Interest Rates?|url=https://www.pbs.org/newshour/economy/whats-the-relationship-between|access-date=2020-08-31|website=PBS NewsHour|language=en-us|archive-date=2021-01-24|archive-url=https://web.archive.org/web/20210124042222/https://www.pbs.org/newshour/economy/whats-the-relationship-between|url-status=live}}</ref>

===Liquidity===

[[Market liquidity|Liquidity]] is the ability to quickly re-sell an asset for fair or near-fair value. All else equal, an investor will want a higher return on an illiquid asset than a liquid one, to compensate for the loss of the option to sell it at any time. U.S. Treasury bonds are highly liquid with an active secondary market, while some other debts are less liquid. In the [[mortgage]] market, the lowest rates are often issued on loans that can be re-sold as securitized loans. Highly non-traditional loans such as seller financing often carry higher interest rates due to a lack of liquidity.