The Basics of Interest Rates

The cost of money is the opportunity cost of holding cash instead of investing it, depending on the interest rate. An interest rate is the rate at which a borrower pays interest for using money that they borrow from a lender. Market interest rates are driven mainly by inflationary expectations, alternative investments, risk of investment, and liquidity preference. The term structure of interest rates describes how interest rates change over time.

Understanding the Cost of Money

The cost of money is the opportunity cost of holding money instead of investing it, depending on the rate of interest.

LEARNING OBJECTIVE

• Explain the sources of the cost of money

KEY POINTS

• The concept of the cost of money has its basis, as does the subject of finance in general, in the time value of money.
• The time value of money refers to the fact that a dollar in hand today is worth more than a dollar promised at some future time.
• The trade-off between money now (holding money) and money later (investing) depends on, among other things, the rate of interest you can earn by investing. Therefore, interest is the cost of money.

TERMS

• Opportunity cost

The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable foregone alternative.

• interest rate

The percentage of an amount of money charged for its use per some period of time. It can also be thought of as the cost of not having money for one period, or the amount paid on an investment per year.

The concept of the cost of money has its basis, as does the subject of finance in general, in the time value of money. The time value of money is the value of money, taking into consideration the interest earned over a given amount of time. If offered a choice between $100 today or$100 in a year's time - and there is a positive real interest rate throughout the year - a rational person will choose $100 today. This is described by economists as time preference. Time preference can be measured by auctioning off arisk free security--like a US Treasury bill. If a$100 note, payable in one year, sells for $80 now, then$80 is the present value of the note that will be worth \$100 a year from now. This fee paid as compensation for the current use of assets is known as interest. In other words, the concept of interest describes the cost of having funds tied up in investments or savings.The cost of money is the opportunity cost of holding money in hands instead of investing it.

Furthermore, the time value of money is related to the concept of opportunity cost. The cost of any decision includes the cost of the most forgone alternative. The cost of money is the opportunity cost of holding money in hands instead of investing it. The trade-off between money now (holding money) and money later (investing) depends on, among other things, the rate of interest that can be earned by investing. An investor with money has two options: to spend it right now or to save it. The financial compensation for saving it as against spending it is that the money value will accrue through the compound interest that he will receive from a borrower (the bank account or investment in which he has the money).

Source: Boundless