A:

Interest is simply the cost of borrowing money. As with any good or service in a free market economy, price ultimately boils down to supply and demand. When demand is weak, lenders charge less to part with their cash; when demand is strong, they're able to boost the fee. Demand for loans ebbs and flows with the business cycle. During a recession, fewer people are looking for new mortgages or loans for their start-up businesses. Eager to increase lending, banks put their money "on sale" by dropping the rate.

Supply also changes as economic conditions fluctuate. In this regard, the government plays a major role. Central banks like the United States Federal Reserve tend to buy government debt during a downturn, pumping the stagnant economy with cash that can be used for new loans. The increase in supply, combined with diminished demand, forces rates downward. The exact opposite occurs during an economic boom.

It's important to note that short-term loans and long-term loans can be affected by very different factors. For instance, the buying and selling of securities by a central bank has a much greater impact on near-term lending, such as credit card rates and car loans. For lengthier notes, such as a 30-year Treasury bond, the prospects for inflation can be an important factor. If consumers fear the value of their money will rapidly decline, they'll demand a higher rate on their "loan" to the government.

RELATED FAQS
  1. Is demand or supply more important to the economy?

    Learn more about the impact of supply and demand in an economy. Find out why companies study supply and demand as part of ... Read Answer >>
  2. Do supply and demand always cancel each other out?

    Learn more about supply and demand and how these factors drive economic activity. Find out more about demand elasticity and ... Read Answer >>
  3. Are there any exceptions to the law of demand?

    Learn more about the law of demand and if exceptions exist for different products. Find out more about how price elasticity ... Read Answer >>
  4. What is demand-side economics?

    Learn the basic theory of demand side economics, which emphasizes the importance of aggregate demand and supports government ... Read Answer >>
  5. How does the law of supply and demand affect monetary policy in the United States?

    Learn about how the law of supply and demand affects monetary policy in the United States. Changing interest rates leads ... Read Answer >>
  6. What's the difference between regular supply and demand and aggregate supply and ...

    Understand how businesses use supply and demand and aggregate supply and demand to forecast economic activity. Learn about ... Read Answer >>
Related Articles
  1. Insights

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  2. Personal Finance

    How Banks Set Interest Rates on Your Loans

    Many factors go into how banks set interest rates for loans. Use this information to negotiate the best possible rate when you're borrowing.
  3. Insights

    An Introduction to Government Loans

    Government loans further policymakers' efforts to create positive social outcomes by offering timely access to capital for qualified candidates.
  4. Personal Finance

    How To Apply For a Personal Loan

    Learn about different avenues for applying for a personal loan, and learn valuable tips to help you get your personal loan application approved.
  5. Investing

    Forces Behind Interest Rates

    Interest is a cost for one party, and income for another. Regardless of the perspective, interest rates are always changing.
  6. Personal Finance

    Personal Loans vs. Car Loans

    How to tell whether a personal loan or a car loan is better for you.
  7. Personal Finance

    Different Needs, Different Loans

    Find out what options are available when it comes to borrowing money.
  8. Personal Finance

    Understanding Loans

    A loan is the act of giving money, property or other material goods to another party with the expectation of being repaid.
  9. Personal Finance

    8 Top Alternatives to Car Title Loans

    Before you sign up for a car title loan, investigate these 8 alternate strategies.
  10. Personal Finance

    All About Government Loans

    There are many reasons to seek a government loan rather than one from a private lender. Government loans typically have low interest rates and offer fixed or subsidized options, as well as deferred ...
RELATED TERMS
  1. Demand

    An economic principle that describes a consumer's desire and ...
  2. Law Of Supply And Demand

    A theory explaining the interaction between the supply of a resource ...
  3. Loan

    The act of giving money, property or other material goods to ...
  4. Direct Consolidation Loan

    A loan that combines two or more federal education loans into ...
  5. Origination

    The process of creating a home loan or mortgage. During the origination ...
  6. Unsecured Loan

    A loan that is issued and supported only by the borrower's creditworthiness, ...
Hot Definitions
  1. Sharpe Ratio

    The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such ...
  2. Death Taxes

    Taxes imposed by the federal and/or state government on someone's estate upon their death. These taxes are levied on the ...
  3. Retained Earnings

    Retained earnings is the percentage of net earnings not paid out as dividends, but retained by the company to be reinvested ...
  4. Demand Elasticity

    In economics, the demand elasticity refers to how sensitive the demand for a good is to changes in other economic variables. ...
  5. Dark Pool

    A dark pool is a private financial forum or exchange for trading securities.
  6. Quadruple Witching

    The expiration date of various stock index futures, stock index options, stock options and single stock futures. All stock ...
Trading Center