Saturday, February 27, 2010

Do You Know, What is Interest?

Unless you have a degree in finance, you probably don't know all that you need to know in order to be an informed, responsible credit card user. Now you don't need to be a finance expert to comprehend the basics covered in this article, but after reading it, you might feel like one the next time the subject comes up with your co-workers, friends, or family.

What is Interest?

If you borrow $5,000 from your grandma and promise to pay her back in six months, you might return $5,000 to her a year later. Grandma would probably be happy with that because she loves you. But if you wanted to borrow $5,000 from a bank, you know you would not get off the hook nearly as easily. The bank would almost definitely expect regular monthly payments, and would absolutely expect to be compensated in the form of interest. But compensated for what? So long as you pay back the money, why should the bank deserve any extra compensation?

Interest is first and foremost, compensation for what is known as "default risk." When you borrow money from the bank, there is a chance you won't pay it back. There's an even greater chance that you won't pay it back in full, or that the bank will spend time and money bugging you about late payments. If not for interest, it would only take one missed payment by one borrower for the bank to lose money. Therefore, the bank must charge interest in order to offset deadbeat debtors and make a little (or not so little) profit for itself. Otherwise, why be in business?

Secondly, interest is charged on loans because the use of money is "mutually exclusive." If the bank has only $5,000 in its vault, it can't lend $5,000 to you and to your sister. (Actually it can, but how banks are able to do this is well beyond the scope of this article). Imagine your friend wanted to borrow $50 from you, but if you lent the money to him, you wouldn't be able to take your girlfriend out to a fancy dinner. How much "compensation" would make lending him the money worth it to you? How much would you have to add in to cover his "default risk?"

A third reason that interest must be charged is inflation. If you borrowed $5,000 in 1966 and paid it back in full 40 years later, much of the value of the money would have evaporated. In order to replace the buying power that $5,000 had in 1966, you'd have to come up with more than $31,000 in 2006 dollars. Inflation is a constant fact of life in America (and around the world), so at the very least, interest must offset it. In recent times, inflation in the US has been hovering around 3 percent per year.

How Do Credit Card Companies Determine Interest Rates?
Credit card companies exist to make money, and they do this by charging interest and fees. In order to attract the most business possible, they offer different interest rates and fee schedules to different people. In business lingo, this is called "price discrimination," but don't bother contacting your lawyer - this form of discrimination is perfectly legal (if a bit unfair at times).

Credit card companies consider your default risk, the cost of lending (taking into account the mutual exclusivity of money use), and inflation expectations in determining the interest rate you will pay. Obviously, only default risk is unique to you, and it is determined by your credit history. The better your credit, the lower the interest rate you'll be offered.

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