Investors need to understand the chances for interest rates to increase or decrease while they value their investments. However, knowing what causes interest rates to rise needs a deep understanding of the various complex factors that contribute to these changes. These factors include supply and demand, inflation, the government, as well as time.
What is an Interest rate?
An interest rate is said to be the cost of borrowing money. On the other hand, it is simply the risk of lending money and the compensation for the service the lender provides. Either way, interest rates keep the economy moving by motivating people to borrow money, lend money, and spend money.
However, existing interest rates are prone to changes, and interest rates differ based on the types of loans. If you are a borrower or lender, you must understand the causes of these changes.
Why do Interest rates change?
Interest rates are bound to change over time and these changes are reflections of the demand from loan borrowers and the supply of money available by lenders. You can think of it as the “price of money”.
Basically, if a borrower needs to spend more than the money he has, the borrower needs to find a lender to provide him with extra funds. The lender will then think about the benefits of lending out money as a means of investment compared to keeping the money for spending.
Both the borrower and lender will consider the interest rate paid on the loaned amount in terms of percentage. For example, the N5 interest payment on an N100 loan, which is left for one year is termed a 5% interest rate.
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What factors cause an increase in Interest rates?
Here are the major factors that cause an increase in interest rates:
1. Supply and Demand
The supply and demand of credit is a major factor that influences interest rates. Basically, a rise in the demand for money will increase interest rates. On the other hand, a fall in the demand for money will decrease interest rates.
Alternatively, a rise in the supply of money will decrease interest rates while a fall in the supply of money will increase these rates.
2. Inflation
Inflation also affects interest rates. The greater the inflation rate, the more likely that interest rates will rise. Basically, this happens because lenders will request higher interest rates to act as compensation for the decline in purchasing power of the money borrowers will pay them in the future.
3. Government
The government also has a say in how interest rates are affected. To a large extent, the Central Bank of Nigeria can influence the interest rates in Nigeria.
4. Time
Time is another major factor that affects interest rates. Essentially, long-term loans have a bigger chance of not being paid back since there is more time for a misfortune to happen that can lead to default. This makes long-term loans very risky. Hence, the longer the loan term, the greater the interest rate.
The Bottom Line
As a borrower or lender, you must understand what causes interest rates to rise. Basically, these rates are affected by factors like the forces of supply and demand, inflation, the government, and time. Hence, before you invest in any security or before you borrow money, you need to use these factors to determine the influence they will have on your interest rate.
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