Interest Rate Risk

Finance a la shmoop how are interest rates determined? mm-hmm...so imagine

this some nice stranger out there just pre-approved you for a credit card [Person thinking about credit cards]

groovy looking over the paperwork you got in the mail however it appears

there's a 20% interest rate attached awesome ish except you have no idea what

an interest rate is why it's that percentage or who set it at 20% well

congratulations you're about as clueless as the typical 35 year old these days [Woman walks into lamp post holding credit card]

but here's the lowdown for every thousand bucks you borrow on that credit

card you'll be paying two hundred bucks a year to rent that money and you'll

continue to pay that every year until both the principal and the interest of

your loan are paid off well there are two elements to an interest rate one [Elements to interest rate appear]

element is the economy the world's interest rates are generally set by

governments seeking to either add fuel to the flame of the economy by lowering

rates and making money cheap to borrow so people spend and hire people or they're

trying to suck oxygen from its thirsty gaping maw so that the world's economies

are relatively stable and inflation is under control meaning they make the cost

of borrowing money high so the pricing doesn't get out of control and that's

for a different video and we'll get to that later...when economies are weak

the government lowers interest rates right they're hoping to encourage people

to spend money greenlight new projects hire new bodies [People shaking hands]

do stuff with their dough low interest rates on credit cards are generally a

good thing for consumers seeking to buy tchotchkes like earrings and belly rings

at a mall so that is if your credit card only charged you 2% a year in interest [Interest of credit card formula appears]

well that'd be 20 bucks a year to rent that grand and with cheap money

available to you well you'd be happy to buy more belly rings on credit well

things work in the opposite direction as well when economies get too hot and

inflation runs out of control governments seek to cool things down by

raising the cost of money when inflation is very high bad things happen generally

to old people which sucks because we love the [Old man falls over]

guys they always have butterscotch candy take for example someone who lives on a

pension that pays them say 3% a year like it's all in bonds because they have

to be safe they can't take stock market risk so they only get 3%

well if inflation skyrockets and it's 10% a year well in a very short time

period they're spending dollar buys only half as much as it used to and while

then you can find these people living in a station wagon from the 70s parked on [Old man and woman sitting on chairs]

your local curb got it so if inflation is 10% they're only getting 3 they're

losing 7 percent of their buying power every year so that was the capital

markets price of money I.e what's the price the government

sets for the cost of its best customers to borrow money yeah that's the Fed

that's kind of how they price lending money to banks all right well who are

the best customers Google, Bill Gates that nun who just won the lottery [Nun appears in church]

but that doesn't tell the whole interest rate story here why would you be charged

20% interest on your credit card and Bill Gates only 3% one word risk if

you're Bill Gates who's got like roughly a bajillion dollars and you're taking a [Bill Gates relaxing in a chair]

loan for a short duration and have a long history of paying back your debt

well you're a low risk to pay back that thousand dollars bill borrowed to put

his bellybutton ring in at the mall and a bank can afford to charge him a small

interest rate because it's so likely they'll get paid back whereas if you're

just some bum named Gil Yates no relation obviously and you have five [Gil standing at a bus stop]

dollars to your name and are a huge flight risk well a bank is probably not

going to be too excited to offer you any loan at all and if they did it would

feature an extremely high interest rate to make up for the risk of you not

paying them back right if you were the bank you'd probably do the same thing

so who's the magic wizard behind the curtain who sets these things in the [Interest rate appears from out of magicians hat]

first place and how does that work well financially the US is still the center

of the world the Fed is the American vehicle which

sets the price to banks for borrowing money the Fed, the Fed yeah it sounds

kind of kind of like big shot there right well structurally banks might pay

1% to the government to borrow money and then they might mark up the price of

that money to 5% make 4% spread between the bid and the ask

price of the debt that they basically buy from the government and then resell

to people like you and me... in English you bet say a bank takes a million dollar

loan from the Fed it'll pay $10,000 a year in interest to the Fed for [Interest payment calculation appears]

borrowing that money if it turns around and loans money to Joe the Plumber

a million dollars for his parts distribution business charging him 5%

per year well then Joe pays the bank 50 grand a

year to rent that money and the bank shows a gross profit thereof $40,000 a

year just for kindly Joe that's 50 minus 10 you know some heavy calculus there

now while all of this might sound like the financial gravy train is not that [Gravy train of money goes by]

simple Joe the plumbers business well like that kind of business goes bankrupt

all the time and when that happens banks don't get paid back the million bucks

they loaned Joe sometimes they get zero the banks are however still on the hook

for the million dollars they borrowed from the American federal system if the

bank doesn't pay back the Fed well they basically all go to jail and get

tortured in Guantanamo or something like that oh wait we don't torture anymore do

we oh we do all right then well then you

don't want to default on the Fed so anyway that widespread of 4% has to cover

a lot of deadbeats who don't follow through on their promises to pay back

the money they borrow that's how it works in the US and most Western [Western countries highlighted on map]

countries have more or less the same system the numbers may seem small to you

but over time they really add up if you borrow $10,000 at a 20 percent

annual rate and it takes you ten years to pay off that money well your total

interest would be and strap yourself in there here's the math it's ten thousand

times the quantity one plus 0.2 which is the 20% there to the tenth power that's

how you do the math there so what's 1.2 to the 10th which reflects the

compounding of that interest rate for about ten years well it's about 6.2

how do you get the math well you multiply that number by 10,000 which

revealed that a 20% interest rate on a 10-grand loan for 10 years cost you

about 62,000 big ones 10 grand it really cost you 62... [Bill gates appears]

compare that to Bill Gates who can spend $10,000 on a cheap card costing 3% and

doesn't pay it back for 10 years well here's the difference the cost of

renting that 10 grand for 10 years at 3% well it's about 1.35 and yes Bill's

cost of renting that doe for 10 years 13.5 grand vastly cheaper because

well Bill is a vastly safer bet to pay back his debt than you are as for that [Interest rates for Bill and Joe appear]

20% rate on your new credit card well it sounds steep but it's sadly pretty

average just be sure to pay it off each month because if you get way behind in

your payments well, the magic wizard behind the curtain isn't going to swoop

in to save you sorry just keeping it real