Understanding Different Interest Rates

Understanding Different Interest Rates There are a variety of different types of interest rates, but in order to understand these, one must first understand that an interest rate  is a yearly price charged by a lender to a borrower in order for the borrower to obtain a loan, usually expressed as a percentage of the total amount loaned. Interest rates can either be nominal or real, though certain terms exist to define specific rates such as the Federal Funds Rate. The  difference between nominal and real interest rates  is that real interest rates are ones that are adjusted for inflation, whereas nominal interest rates are not; the interest rates one typically finds in the paper are nominal interest rates. The federal government of any given country can affect the interest rate, known in the United States as the Federal Funds Rate and in England as the Prime Rate. Understanding the Federal Funds Rate The Federal Funds Rate is defined as the interest rate at which U.S. banks lend to one another their excess reserves held on deposit at the United States Treasury Department, or the interest rate that banks charge each other for the use of Federal funds in general. Investopedia describes the Federal Funds Rate as the rate of interest banks charge other banks for lending them money from their reserve balances on an overnight basis. By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. Any money in their reserve that exceeds the required level is available for lending to other banks that might have a shortfall. ï » ¿Essentially what this means for the average American is that when you hear that the Federal Treasury Chairman has raised interest rates, theyre talking about the Federal Funds Rate.  In Canada, the counterpart to the Federal Funds rate is known as  the overnight rate; the  Bank of England  refers to these rates as the base rate or the repo rate. Prime Rates and Short Rates The Prime Rate is defined as a rate of interest that serves as a benchmark for most other loans in a country. The precise definition of prime rate differs from country to country. In the United States, the prime rate is the interest rate banks charge to large corporations for short-term loans.​​ The prime rate is typically 2 to 3 percentage points higher than the Federal Funds rate. If the Federal Funds rate is at around 2.5%, then expect the prime rate to be around 5%. The short rate is an abbreviation for short-term interest rate; that is, the interest rate charged (usually in some particular market) for short-term loans. Those are the major interest rates you will see discussed in the newspaper. Most of the other interest rates you see will usually refer to an interest-bearing financial asset, such as a bond.