WHAT ARE “INTEREST RATES”?

An interest rate is the price of money. The nice thing about defining the interest rate as the price of money is that you don’t have to specify whether it is a rate for borrowing (a cost) or a rate for lending (a benefit), though, as with every price in the financial markets, you should be prepared to encounter a bid–ask spread in the world of interest rates as well. If you decide to borrow USD 100 today, then in one year’s time you would be obliged to pay back USD 105.20. That ratio, USD 105.20/USD 100, reflects the interest rate. That being said, if you borrow USD 100 today at an interest rate of r = 5.20%, then in one week you would pay back only USD 100.10. Where did this come from? You would have to scale the interest rate for the time period involved (and here I assume that one week is exactly 1/52 of a year). The math would look like this FV = PV(1 + rt) (3.1) where we use PV to refer to the Present Value or Principal FV to refer to the Future Value r to indicate the (annualized) interest rate and t to reflect the time period over which the borrowing or lending takes place (measured in years) For the example we just looked at 100.10 = 100(1 + (.0520)(1/52)) and, for our earlier example: 105.20 = 100(1 + (.0520)(1)) This convention is known as simple interest and, if the time frame under consideration is a year or less, this is one of the most common ways in which interest is calculated.