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Interest Rates Vary
Interest rates paid on different loans are not necessarily the same. Some loans will be made at a
higher interest rate and some at a lower interest rate. Interest rates vary depending on:
1. Risk. The greater the risk that the borrower will not repay the loan, the higher the interest rate
the lender will demand. A lender may be willing to make a loan to a high risk borrower, but
only if the lender can earn a high enough interest rate on the loan to justify the high risk.
Example 6: The federal government often borrows billions of dollars at a time. It is able to borrow
at a low interest rate, because lenders consider loans to the federal government to be extremely
low risk. On 12/16/14, the yield on a 10-year U.S. Treasury Bond was 2.05%. On that same day,
the yield on an AAA rated 10-year corporate bond was 3.05% and the yield on an AA rated 10-
year corporate bond was 3.18%.
2. Term of the loan. Generally, the longer the term of the loan, the higher the interest rate. For
instance, a 30-year mortgage will generally have an interest rate about .5 percent higher than
a 15-year mortgage.
Example 7: On 12/16/14, the yield on a 30-year U.S. Treasury Bond was 2.69%. On that same
day, the yield on a 5-year U.S. Treasury Bond was 1.51%.
3. Relative cost of making the loan. The cost to process a small loan may be the same as the
cost to process a large loan. But the cost of processing the small loan is greater relative to the
size of the loan. The greater the relative cost of making the loan, the higher the interest rate.
Example 8: Ardell and Bertha both want to take out 5-year personal loans from 1 st Bank. Ardell’s
loan is for $500,000 and Bertha’s loan is for $5,000. The cost to the bank of making (processing)
the two loans may be about the same. Assuming that both loans have the same risk, Ardell’s loan
will have a lower interest rate. The relative cost of making Ardell’s loan will be less than the
relative cost of making Bertha’s loan.
Real Interest Rate
The rate of interest that reflects the true cost of borrowing and the true gain from lending is the
real interest rate.
Real interest rate – nominal interest rate minus the rate of inflation.
Example 9: Arlene agrees to loan $10,000 to Professor at a nominal (named, stated) interest rate
of 10%. The rate of inflation is 3%. What is the real interest rate on the loan? Answer; 7% (The
10% nominal interest rate minus the 3% rate of inflation).
Present Value
What makes an asset valuable? An asset is valuable because we expect a future benefit from the
asset. For a business asset, the future benefit is usually an amount of income or a stream of
income to be received in the future. But income to be received in the future is not the same thing
as income received today. There is a time value to money. If we have money today, we can
consume today. Current consumption is more valuable than future consumption and earlier
consumption is more valuable than later consumption, because consumers have a positive rate of
time preference.
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Another reason that money received today is more valuable than money to be received in the
future is interest. If we have the money today, we can invest the money and earn interest. This
will give us a larger amount of money in the future. The sooner that we have the money to invest,
the more money that we will have in the future.
Interest, Present Value, Rent, and Profit 26 - 4