When I Borrow Money, How is Interest Computed? By Leon Presser- author of What it Takes to become an Entrepreneur
Whenever you borrow money you pay a rate of interest on the monies you borrow. Different lenders may employ different benchmarks upon which they base the interest rate that they wish to charge you for your loan, or you may simply be asked to pay a fixed interest rate. You should have an understanding of the key benchmarks that are typically utilized. It will save you money! Prime rate After a history of banking crises, the United States created the Federal Reserve System in 1913 as the central banking system of the country. As part of its responsibilities, the Federal Reserve System supervises and regulates banking institutions. In the United States banks are required by law to maintain certain levels of cash reserves. If for any reason the bank’s cash reserves are reduced so that it goes below the required legal level, it can borrow money for a short term from other banks. The Federal Reserve System sets the ‘federal funds rate,’ which is the interest rate at which banks can lend to other banks. This federal funds rate is set by a committee that meets eight times per year. At each meeting the committee decides whether to increase, decrease or leave as it is the then current federal funds rate. In the United States, the interest rate charged by banks to their most credit-worthy customers is called the prime rate. Typically, the prime rate runs approximately 3 percent above the federal funds rate. Note that a bank’s prime rate does not change on a regular basis; rather, it changes as a consequence of changes to the federal funds rate. The prime rate is used as a reference line when lending to consumers. For example, your bank may offer you a loan with an interest rate of ‘prime plus 1.’ This means you will be charged one percent above the prevailing prime rate. Thus, if the current prime rate is 5%, you will pay 6% interest. The Wall Street Journal publishes on a regular basis a prime rate that represents a composite of the prime rate charged by 75% of the 30 largest banks in the United States. This prime rate index is the one used in many contracts. During 2008, the prime rate ranged from a historical low of 3.25% to a high of 7.5%. LIBOR The London Interbank Offered Rate (LIBOR) originated in London, England, around the year 1985. This rate is fixed by the British Bankers Association each day at 11 a. m. London time. The
rate is an average derived from the quotations provided by a group of 16 banks determined by the British Bankers’ Association. LIBOR is the rate at which banks lend to each other in certain London money markets. Note that LIBOR is a floating rate: it fluctuates continually. LIBOR is a benchmark interest rate used as a reference in lending and borrowing transactions around the globe. In particular, many corporate loans are indexed to LIBOR, as well as many adjustable-rate mortgages. For example, you may be offered a loan with an interest rate of ‘LIBOR plus 1.’ This means you will be charged one percent above the daily LIBOR rate. Generally, the higher the LIBOR rate, the tighter the credit markets. Prime rate versus LIBOR The prime rate is fixed for extended periods of time while LIBOR is set daily. The prime rate is tied to the federal funds rate, which is targeted by the United States government. LIBOR is determined by market quotations in London. Generally in normal markets LIBOR runs slightly above the federal funds rate, typically 0.15% to 0.20%. A wider spread between these two benchmarks indicates uncertainties in the world credit market. For example, in the midst of the financial crisis of 2008, a wide spread developed between these two rates with LIBOR at times running well over three percentage points above the federal funds rate. Other benchmarks In some instances other dynamic benchmarks or indexes are used to serve as the basis of the interest rate you pay. For example, the cost of savings index (Cosi), which is tied to the performance of a bank’s deposits, has been employed by some banks to determine adjustablerate mortgages. Typically, you are charged an interest rate 2% to 3% above the chosen index. When discussing interest rates another common term used is ‘basis points.’ One hundred basis points constitute one percent. So, for example, if your lender says that he/she will charge you prime plus 125 basis points for a loan that means you will be charged prime plus 1.25%. To check on the prime rate, LIBOR, and other rates you can go to www.bloomberg.com or to The Wall Street Journal. So, the benchmark that is employed for any loan you may take could make a serious difference on the interest you pay for the loan. Before you sign on a loan make sure you fully understand the benchmark upon which it is based! Of course, I must tell you that I do cover this topic and related issues in more detail in the book. I do want you to read the book. I also encourage you to go to the book’s website
(www.whatittakestobeanentrepreneur.com) and subscribe so that you will be notified each time a new post occurs. (Some information from Wikipedia and the Wall Street Journal was helpful in writing this posting)
Published on Feb 12, 2010
Whenever you borrow money you pay a rate of interest on the monies you borrow. Different lenders may employ different benchmarks upon which...