An interest rate is a rate that is charged on a loan or a rate given for a deposit to a bank that is a percent of the total money amount. Excess interest rates are called usury and are against the law. However, an interest rate that was considered as usury 50 years ago, is now "the new normal". Financial institutions can usually charge interest rates that are greater than individuals can charge when they make private loans to other individuals or via credit cards.
Interest rates paid by banks on deposits
In general, banks have two types of accounts: checking and savings. Historically, banks did not pay interest on checking account balances and paid interest on savings accounts (including certificates of deposit.) In the United States, savings and loan associations were regulated and the federal government set the interest rates paid on deposits. After regulation was lifted, savings and loan associations and other banks competed for deposits by raising their interest rates. Because the amount paid to attract and hold customers were more than they could afford to pay, many savings and loan associations folded.
A person depositing money in a bank faces two risks: that the bank will fail and that the value of the deposit will be worth less due to inflation. In theory, banks should be able to offer interest rates that are higher than the cost of inflation. However, for several years now the inflation rate (see also Consumer Price Index) is greater than the interest money paid by the banks, thus one actually loses money compared to investing in tangibles or inflation hedges. For example, a good or service costing $1000 in 2004, the same item would cost $1,242.89[1] ten years later in 2014 due to the cumulative rate of inflation of 24.3% over those ten years.
Banks can also offer certificates of deposit where the money is tied up for a set length of time earning a set interest rate. Generally speaking, the longer the period of time the money is tied up, the greater the interest rate it will earn.
Interest rates can be either fixed (fixed rates) or they can change (adjustable rates). Rates on savings and checking accounts in a bank will usually change over time whereas a certificate of deposit will usually have a fixed rate for the life of the contract.
Because federal deposit insurance guarantees that deposits up to a specified limit will not be lost in the event of a bank failure, the interest rate paid by banks does not compensate for that risk and is lower than the interest rate offered by non-insured sources, such as money market funds or corporate bonds.
References
- ↑ http://www.usinflationcalculator.com The US Inflation Calculator measures how the buying power or purchasing power of the US dollar has changed over the years by using the latest Bureau of Labor Statistics (BLS) inflation information provided in the Consumer Price Index (CPI). http://www.usinflationcalculator.com/frequently-asked-questions-faqs/#HowInflationCalculatorWorks Accessed April 6, 2014