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What function do interest rates have in investments and loans?

Interest is the price for borrowed capital. In other words, if someone obtains capital through a loan, he must pay a price to the lender for providing the capital. This price is the interest. As a rule, the interest is added to the amount of the loan as a previously determined percentage.

Interest that a borrower pays is called debit interest. Interest that an investor receives is called credit interest. For many years, banks have granted investors interest on the money deposited in a bank account. Due to the low interest rate policy of the central banks, hardly any or only very low interest rates are currently paid for savings deposits. Investors may have to switch to other asset classes for attractive returns.

There is not only interest on monetary capital, but also on capital in kind - this includes, for example, the rent for an apartment or property.

What do the interest rates depend on?

How high the applicable interest rate is can depend on various factors. These include, for example:

  • the level of the European Central Bank (ECB) key interest rate

  • creditworthiness and Schufa information of the borrower

  • type and purpose of the loan, for example personal loan or construction financing

  • supply and demand balance

  • duration of the loan

No matter whether you want to borrow money or invest money: it is worthwhile not only to ask at the house bank, but to compare offers of different banks and find the best offers and conditions.

Why is there interest?

For creditors and banks, interest is a compensation for the risk they take on account of the capital provided. After all, there is some residual uncertainty as to whether the debtor will actually repay the money in full to the bank or creditor. With a higher risk from the point of view of the lender, for example because the debtor has a poor credit rating, the risk premium - i.e. the interest rate - increases. Furthermore, the interest rate should also compensate for inflation, because while the creditor cannot dispose of his capital, it is subject to a loss of purchasing power.

What is the difference between nominal interest rate and real interest rate?

With the so-called real interest rate, inflation is already calculated from the interest rate, i.e. it is adjusted for inflation. The opposite of the real interest rate is the nominal interest rate. The nominal interest rate does not yet take inflation into account.

What is compound interest?

Albert Einstein is said to have once described the interest rate as the eighth wonder of the world. Thanks to compound interest, investors can build up considerable assets over time, even with relatively small investment sums. In order to make use of the compound interest effect, the interest of a financial investment is not distributed but reinvested. The investment sum is thus increasing continuously. And since the reinvested interest is again subject to interest, the investment sum increases exponentially. Compound interest is particularly noticeable for long-term investments. It can be calculated with the formula

Kn=K0?(1+p/100)n

where K0 is the initial capital, p is the interest rate and n is the duration.

The story of the "Joseph's penny" illustrates what exponential growth means: The thought experiment of the British economist Richard Price assumes that two thousand years ago Joseph invested a single penny in a bank for his son Jesus for four percent interest per year. How much money would Jesus have today, after the single penny has earned interest and compound interest? In 2012, the amount would have been an incredible 186,671,780,195,916,000,000,000,000,000,000 euros. For comparison: Calculated in gold instead of euros, that would be 255 globes of pure gold.

Why is the low interest rate a problem?

In recent years, the European Central Bank (ECB) has lowered key interest rates to stimulate economic growth. Borrowing money from banks is therefore cheaper than ever before. Conversely, however, the banks do not offer the possibility of earning attractive interest rates with savings deposits. The low interest rates are not only affecting Germany, but all of Europe, and the US Federal Reserve has also lowered its key interest rate again, among other things in the wake of the Corona crisis in March 2020. In a low interest rate phase, inflation can be higher than the interest that savers and investors receive on their capital. The real interest rate thus slides into negative territory. This means that depositing money in an account at the banks, will gradually reduce the value of the assest.