Credit impacts the world economy and fosters most transactions today. When individuals and businesses understand that they can get capital that they can repay later, they tend to spend more. If a person needs something, they can take loans that get repaid over a specified period. If a business has too much money tied up in other projects, it can get credit to invest in an opportunity.
Nevertheless, lenders that offer credit need some form of incentive to give up those loans. That incentive is referred to as interest. Interest rates in economies affect the price of securities, including cryptocurrency. For instance, the value of crypto like celo price could get impacted depending on whether the interest rate of a nation like the US is increased.
Understanding interest rates
Interest is the extra cash on top of an original loan made to a borrower. If Larry borrows $10,000 from Bobby, Bobby will give Larry the cash but with a particular interest rate. If the interest rate is 10%, it means that Larry will pay back the $10,000 plus interest of 10% of the $10,000.
In simple terms, it means that Larry will pay $10,000, which is the principal, and an extra $1,000, which is 10% of the original $10,000 borrowed. In essence, Larry gave out $10,000 and received $11,000. That extra cash motivates Larry to lend funds to borrowers.
You need to understand that interest rates affect specific periods. For instance, that 10% interest rate might affect a particular month, year, or another specified period. If Larry negotiated 10% interest each year, every extra year would incur an added $1,000 payment.
If the interest rate is compounded, the $1,000 will become even higher since the principal would increase yearly.
The Importance of interest rates
Interest rates are crucial because they affect many things within an economy. The best instance to understand how interest rates work is a commercial bank. Commercial banks typically make money by borrowing and lending funds.
You practically lend the bank money every time you deposit into your account. That’s because the bank can only borrow a percentage of the funds they hold. Your money is pooled together with other deposits, and you share a part of the interest. However, when you take a loan from the bank, you incur interest payments based on the amount you borrowed.
Commercial banks are very limited when it comes to adjusting interest rates. It’s the job of a central bank like the US Federal Reserve, the European Central Bank, or the Bank of England to adjust the rate based on the state of the economy.
Thus, if you deposit more cash into your bank account, you receive a bigger percentage of your money as interest. Similarly, if you borrow money from a bank, you have to pay a bigger percentage of the principal as interest. In essence, a high-interest rate gives more money to lenders.
Low-interest rates mean you get a smaller percentage of your deposits as interest. You also pay lower interest when you borrow funds to purchase some commodity or patronize services.
With high-interest rates, households in the economy tend to save more since they receive more money from their deposits. They also tend to spend less since they incur higher interest when they borrow loans to make purchases.
The same goes for the firms in the economy. If borrowing money costs too much, they’ll slow down on investments since the risk might not be worth it.
Low-interest rates encourage spending by households and firms in an economy. It also encourages spending since there will be a reduced interest burden on borrowing to purchase goods and services. If there isn’t a tremendous financial incentive to lend money, the funds get spent.
How interest rates affect cryptocurrency prices
There has been a lot of talk about the interest rate hike by the US Federal Reserve and how it’s affecting the price of various cryptocurrencies. Since you know that people tend to save when interest rates are higher, they avoid risky assets during these periods.
Risky assets like cryptocurrencies, stocks, and precious metals are volatile and might give negative returns to investors. However, when investors understand that they can get the same returns for depositing their money in banks, which amounts to less risk, they save more.
That’s one of the reasons for the further drop in the price of bitcoin and other cryptocurrencies against the US dollar. If the interest rate set by the US Federal Reserve becomes lower, investor sentiment toward digital currencies would be positive.
Interest rate is a term that is commonly heard but not fully understood by all. The rate of interest on principal that a borrower is required to pay a lender usually affects the lender’s propensity to loan out money.
Higher interest rates mean more money to a lender; the opposite is true for lowered interest rates. That’s why spending slows down in the economy when a central bank increases the interest rate, and people save more. The interest rate is negatively correlated with the price of various cryptocurrencies. In essence, the higher the interest rate, the lower the prices of digital currencies.
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