An Interesting Subject?

By Derek Beese

In some of my previous posts I have discussed Interest, but perhaps we should ask ourselves “What is Interest?” Forgive the pun but it is a very uninteresting topic for non – financial people, though everyone really should take a moment to think about it because it affects all of us for the majority of our lives. If it is so fundamental to our lives shouldn’t we learn to understand its effect on us and how to use it, rather than be used by it?

Firstly, what is it?  Easy – we all know that it is the exorbitant charge that we have to pay on the money we borrow to buy our houses or it is that pittance that we are given on our savings. Two apparently different things, but in reality one and the same thing confused by that thing called Human Perception!  It is simply the “cost of borrowing money”.

Any transaction to lend money involves two people (parties), the one who lends and the one who borrows. The lender receives the agreed interest based upon the amount lent and the borrower pays it. Because the amount lent (the principal sum) can vary from very small amounts to extremely large amounts, a custom grew up over the centuries to make it easy to deal with all sizes of transaction in a way that is easily understood. This is called the “Rate of Interest” (or Interest Rate) and is normally stated as a percentage rate per annum.

As we have seen before the word percentage is derived from Latin, as are so many words in the English language, and means “for every hundred”. The words “per annum” are also from the Latin meaning “for each year”. So 1% per annum (one percent for each year) will be “one for every hundred for a period of one year”. 2% pa is two for every hundred for every year. 3% pa is three for every hundred for every year, and so on. The kind of money whether it is Dollars, Pounds, Euros or whatever then defines what currency is involved. So if Mr A wants to borrow from Mr B let’s say $1000 for one year at 5%pa then at the end of that year he has to pay back the $1000 plus $50 as the cost of borrowing the principal amount. If the term ( duration of the agreement) is say two years then the repayment will be $50 at the end of year one and $1000 plus $50 at the end of year two. Easy.

What happens though if Mr A wants to borrow $1,000,000 and Mr B doesn’t have that much? Then Mr A either has to find someone with enough money or has to find a group of different people who will lend him enough small amounts to make up his total. That makes life difficult, so as we have seen before in these blogs, the custom of a middleman grew up, whereby the middleman (a bank) paid the interest to people who had spare money  and then lent this money in larger chunks to businesses so that they were able to trade and collected interest from them. The first group are the “savers” and the latter group are the “borrowers” However the middlemen incurred expenses of their own in giving this service which they could only recover by creating a “spread” into the rates offered. For example, the rate offered to savers would be say 4%pa and the rate charged to borrowers would be 5%pa and the 1%pa difference was used to pay all of their own costs and give them a payment for the service.

But then the governments step in, in the nature of the taxman, and say ” I want a bit if that too” so the rates have to widen to say 4%pa and 5.5%pa so that the tax can be paid.

A word of warning though to all of you borrowers. Most lenders are very reputable organisations but there are always some unscrupulous people out there whose sole aim is to take you for a very expensive ride and these people avoid using the standard custom wherever they can. For example, if Mr A wants to borrow £120 he may be offered it for 24 monthly repayments of £7. It sounds reasonable because it is only £7 per month, but 24 x 7 = 168 so the interest charge is £48 over two years. A simple calculation would be one half of 48 for each year = 24 based on a loan of 120 therefore the annual rate of interest would be 24 divided by 120 multiplied by 100 = 20%pa. That is a very expensive loan!  BUT, the true position is much worse because the original loan was being paid off at the rate of $5 each month within the £7, so the true rate has to be calculated on the average value of the loan over the two year term. This was 120 for the first month, 115 for the second month, 110 for the third month, 105 for the fourth month, and so on until the final payment is made to clear it on the last day of the two years. The real rate of interest charged is therefore £24 per annum based on the AVERAGE amount lent and this is £60. So the real rate charged is 24 divided by 60 multiplied by 100 = 40%pa!!

Because many people in the UK were being caught like this, particularly poorer people who could not afford it anyway, a law was introduced which says that ALL loan offers have to quote what is called an APR. This means Annual Percentage Rate and is the true annual rate of interest being charged on the loan. ( In the illustration above it would be 40%pa) So look out for that APR it is very important to your financial health.

Then for savers there are two types of interest – Simple and Compound. Simple interest says that at the end of each calculation period ,usually one year, the amount of interest will be paid out in cash leaving the principal sum to start earning interest again. So it becomes a regular source of income of a regular amount provided the rate and the principal do not change.

Compound interest does not pay out the interest but leaves it to be added to the principal amount so that the principal grows bigger and bigger each year and consequently earns an increasing amount of interest each year. In other words it earns interest upon interest and grows more rapidly as time progresses.

Compound is obviously the better if the money is not needed but many pensioners rely upon simple interest to boost their pension income when they retire from regular work.

Finally, the rate offered is affected by a number of things. Two of the most important are Risk and Supply. The greater the risk that the principal will not be repaid promptly by a borrower then the higher will be the interest rate charged, until very high risk means no chance of a loan at all.

The other thing – supply – we have seen before when discussing inflation. If there are too few lenders and money is consequently in short supply then the rates will increase to persuade people to save more and this increase will deter borrowers and bring supply and demand back into balance.

So you see, interest does affect you and your finances, so think about it and try to use your knowledge to make your life easier.

So Does This ‘Interest’ Thing Always Work?

By Derek Beese

In some of my previous posts I have commented on money, value and inflation and that governments use interest rates as the first and principal means of stopping monetary inflation, or to be more accurate, to control the degree of inflation to a level that they want.

Does this always work? A good question and the answer is yes and no. It depends on where you are standing at the time. A man, who had lost his way, met another man along the road and asked him how to get to his intended destination. The answer he got was “that is very difficult and if I were you I wouldn’t start from here”! So the short answer for interest rates is, yes it will always work given enough time — but — if you are so far off course that everything is going pear shaped it will not work quickly enough to get back to where you should be.

Ha – Ha, very clever but what does that mean?  Well, if the supply of money is well balanced with the amount of product and both are growing at the same rate the amount of inflation will be negligible and under control and small tweaks in interest rates, up or down, will keep everything rosy. But if the national interest rates have been kept too low for too long this will encourage the country’s people (and businesses) to borrow more and more money to spend which increases the money supply but not necessarily the amount of product. Result = inflation. If this goes on for too long without being reversed then the result is very high inflation and people begin to chase after their belief that this illusion of increasing value is real and will last forever. The Emperor’s New Clothes Syndrome or the Tulip Mania again.

House prices raising so rapidly that people can no longer afford them – very bad news. Increase interest rates to slow demand and get things back towards a balanced situation and those people who have borrowed right up to their absolute financial limits cannot afford the new increased repayments and in time their homes are forfeited and sold to repay the debt. At the same time the demand for houses goes down because the borrowing cost has gone up meaning, fewer buyers, houses for sale are more plentiful and the prices start to drop. Those people who have borrowed the full value of the house now have a problem because their borrowings are more than the value of the house —a thing called Negative Equity. This sequence is like a snowball rolling down a hill, it gathers pace and size as it goes and becomes unstoppable until it eventually reaches the bottom and loses its energy. People lose confidence in the value of the product and that means its monetary value sinks.

When this “fully inflated balloon” situation has been reached, the necessary reduction in demand has very bad side effects because people lose their jobs, which reduces the demand still further and the problem spreads to other product items and affects shops, motor vehicles, transport, holidays and most other things The money supply is contracting dramatically because no-one wants to lend and no-one wants to buy (they are all saving for all they are worth to make sure they do not run out of money to meet their debts). So what is the government to do? The immediate response is to reduce the interest rate rapidly and keep on reducing it until the position stabilizes again. If this does not work and it is unlikely to do so for a long time because confidence has been lost and the rate cannot in any case go below 0%, then the powers that be must start flooding money into the system to support the businesses and services that otherwise will not survive. But the government has to borrow this money which will make the present position easier but at the same time makes “tomorrow” much more difficult when these borrowings have to be repaid. It is a repeat of the original cause of the problem.

If this move fails to stop the slide then lack of confidence in the value of the country’s money will mean that the government will be unable to borrow any more and the last resort is to print its own money which, as has been explained in a previous blog, is self defeating.

This is the point where recession becomes slump as in 1929 and the early 1930s and can only be followed by a surge in inflation many years later when the effect becomes apparent.

This is the present situation in the USA and UK and many other countries throughout the world because in these days of globalisation, the problem spreads worldwide like a disease, but those countries that have been more vigilant and careful can now reap the benefit by being less badly affected.

So this interest thing does indeed always work but it is slow and takes a long time to take effect. If the ship has gone off course too far for any reason and is heading for the rocks there is no time to wait and coarse action must be taken. This can make it heel to an alarming extent and throw all of its contents and people onto the decks and some people will get hurt in the process. But when the correct course has been recovered everything settles down again and it is time to start picking up the pieces. Recessions and even slumps do not last forever but they certainly are not comfortable while they last.