This article should not be construed as financial advice of any kind. The purpose of this article is purely educational
What is Interest Rate?
Anyone who Enters a Bank, or Read the Newspaper, encounters the concept "Interest Rate". What is Interest Rate?
Every working person has an income that she can use to purchase consumer goods such as food, clothing, transportation, education, health, leisure and recreation, or she can keep some of her income as savings for future use.
When we decide to save some of our money, we give up consumer products today. This delay in consumption is painful, so it is considered a cost to us. One of the things that can encourage us to save our money is if we receive compensation for agreeing not to use the money in a given period. A savings plan at a bank works exactly according to this principle. The bank offers us to “close” the savings, i.e. to commit not to use the money for a pre-determined period. In return for this commitment, the bank will pay us interest which is usually stated as a percentage of the amount deposited for savings.
An Example for the Interest Rate
- Example of bank interest: Suppose we have 1000 NIS.
- The bank offers us to deposit the NIS 1,000 into a one-year savings plan at an interest rate of 10%.
- This means that we undertake not to touch the amount of NIS 1,000 for an entire year.
- At the end of the year, we will receive from the bank an amount of NIS 1,000 and up to 10% * NIS 1,000, ie NIS 1,100.
- In other words, in exchange for the waiver of not taking the money out of the savings plan, we received NIS 100 that we did not own.
- The new NIS 100 is the interest we received as compensation for not using the money throughout the year.
We guarantee that we will not use the money for the entire savings period, and we are willing to do so because the bank guarantees us the payment of interest as compensation for not using the money for consumption.
How much interest will the bank be willing to pay to savers?
The interest Rate depends on three components
- The Interest Rate that is determined by the Central Bank. Bank of Israel interest rate – This is the interest rate set by the Bank of Israel, which is the interest rate at which commercial banks (such as Bank Leumi, Bank Poalim, Discount Bank, First International Bank, Mizrahi Tefahot Bank, etc.) can borrow money from the Bank of Israel. Click here to read the post “The Banking System” to learn about the various banks.
- The spread – a percentage determined by the commercial banks and in addition to the Bank of Israel interest rate. The Bank of Israel interest rate plus the spread is equal to the prime interest rate, which serves as the basis for most loans and savings.
- Duration of time in which the customer undertakes not to withdraw the money from the savings plan – the higher this duration, the higher the compensation, i.e. the interest rate.
When we have no money and we want to use the money, we can apply for a loan. A loan is the right to use money that is not ours. Because we have no money and others have money, for others to agree to give up the use of their money, we must compensate them. In such a case in exchange for the right to use a certain amount of money that we do not own, we will have to pay. Interest is the payment we must pay for the right to use money that is not ours. Note that because we have to pay for the loan, the correct terminology is to buy a loan and not take a loan.
In Conclusion
The interest rate is actually the price of holding liquid money. When we do not own liquid money we pay interest for the possibility of holding liquid money. When we own liquid money, we can waive its use for a certain period in exchange for paying interest that we receive from the bank or the person to whom we lent our money.
Banks are the intermediary between those who have liquid money and who deposit it in the bank and those who do not have liquid money who are willing to pay for the right to use liquid money. Why does the bank agree to pay interest to the saving public? Because during the year when savers undertake not to touch the money, the bank can lend it to those who need a loan. The bank will always offer a higher interest rate to the borrower (who does not own liquid money) than he offered to the lender (liquid money holders who close their money for a pre-defined period in a savings plan)
Example
- The bank pays savers 10% interest for depositing the money for a year.
- The bank charges borrowers interest of 15% for a loan repaid after one year.
- In other words, the bank will pay the saver the depositor NIS 1,000 for a one-year savings plan, NIS 1,000 * 10% = NIS 100 interest.
- The bank will charge the borrower NIS 1,000 from the bank per year, 15% * 1000 = NIS 150
- In other words, the bank has an income of NIS 150
- The bank has an expense of NIS 100 For this transaction
- The Bank Earned 50 NIS on this deal
The relationship between the interest rate and the prices of products in the economy, or nominal interest rate versus real interest rate
The interest rates stated in the savings and loan plans are nominal. That is numerical interest. For example, 10% of 1000 is exactly the action of 10% of 1000 i.e. 100.
The real interest rate is the adjustment of the nominal interest rate to a situation of change in the consumer price index.
To understand why prices are rising you are welcome to read the post on inflation.
Once you understand what inflation is, we’ll get back to it.
Suppose prices rose by 2% during the year.
Our saver deposited NIS 1,000, undertook not to touch them all year, and she receives NIS 1,100 at the end of the period.
The problem is that because prices have gone up, the purchasing power of money has gone down. This means that a NIS 100 interest payment she received at the end of the period could not buy the same amount of products she could have bought at the beginning of the period.
The real interest rate is an interest rate calculated taking into account price changes. If prices have risen by 2% during the year, then the NIS 100 we received at the end of the year will be worth as much as NIS 98 in terms of their purchasing power. Therefore the real interest rate, in this case, will not be 10% but 9.8%.
In Conclusion
Interest is the price of using money. Savers waive the use of money for a certain period and therefore receive compensation for this waiver in the form of interest payment. Borrowers pay for the right to use the money for a certain period so they have to pay interest.
