Interest rates vary so much because competing influences act on them. The length of time money is loaned out makes a difference in rates, with money that’s loaned for a longer term usually, but not always, fetching a higher rate of interest.
Another factor that affects interest rates is the credit-worthiness of the borrower. Borrowers are graded, just like students, with grades that measure the likelihood that they’ll repay their loan. Borrowers with credit grades better than an A pay less interest than borrowers whose grade is a B or worse.
Finally, interest rates vary with inflation. Inflation tends to raise interest rates, because it makes the money repaid to a lender less valuable than the money he or she loaned.
Other factors can influence interest rates too, like the use a borrower plans to make of the money, how much money he wants, what kind of collateral she has, the number of borrowers trying to get loans, and competing uses the lender might make of the money instead of loaning it. Loan length, borrower reliability, and inflation, however, may be the most important factors.
The length of a loan: The yield curve
If money is lent for a relatively short period, there is less time for something to go wrong. Therefore, the lender is suffering less risk that the loan will not be repaid. So short-term loans, except at the pawnshop or paycheck lender, generally have lower interest rates than longer loans.
However, there are circumstances in which a short-term loan may pay more interest than a long-term one. If lenders believe that the economy is about to slow, they may buy long-term bonds to tuck their money safely away. Long-term bond yields fall as their popularity rises; their prices rise and their yields fall below those of short-term bonds.
Charts of the behavior of interest rates through time are called yield curves. They are plotted by tracing the percentage of interest paid for various lengths of time for the same kind of loan. For example, a yield curve might plot the amounts of interest paid for U.S. Treasury loans of various lengths.
The shape of the curve is considered a predictor of the economic future. A normal curve, in which lending for long periods pays more than lending for short periods, is supposed to indicate that all’s well.
A curve that is steep, with short-term lending not paying much but somewhat longer lending paying quite a bit more, is supposed to indicate that banks will do well. Some think it’s a signal to buy financial stocks. Some think just the opposite.
An inverted curve, in which short lending pays more than long, is supposed to be a sign of a coming recession,. This sign is truly not infallible.
At any rate, the length of a loan has a substantial impact on its interest rate.
Credit grades: Treasuries through junk
The federal government can tax. Therefore, its credit is considered perfect. Anything it can borrow, it can repay. (There are governments that have failed to repay, but that’s sovereign risk, another topic.) Everyone else, though, gets a grade based on how good the odds of being repaid seem to be.
AAA bonds are investment grade. (Bonds are actually rated a variety of ways. Let’s ignore that in this rough overview.) People who lend money by buying highest rated bonds can feel very sure they will be repaid. Bonds with fewer A’s are not such “sure things,” but do pay more interest.
As bond grades get down into the B’s, risk rises. As the risk of not being repaid increases, interest rates must rise to attract lenders. The more a risk grade sinks, the more interest rates rise. Junk bonds pay high interest because they’re highly risky.
Inflation
Inflation makes money less valuable. If a loaf of bread costs a hundred dollars, there’s been inflation. People who lend money in times when inflation is believed to be about to increase fear they will be paid back in money that is worth less than the money they loaned out. Therefore, in times perceived as inflationary, interest rates rise, to compensate the lender for the possibly decreased value of the money he or she will get back.
In deflationary times, money becomes more valuable, and prices fall. If a loaf of bread costs a quarter, there’s been deflation. In times perceived as deflationary, interest rates should be very low or even negative, because lenders believe they can look forward to being paid back in money that is more valuable than the cash they laid out. In fact, in deflationary times, in certain places, interest rates have been negative.
Inflation, credit ratings, and loan length all affect interest rates strongly. However, people sometimes behave with disregard for these factors. When they do, interest rates can vary for reasons that seem unknowable.
In the end however, risk, or perceived risk, raises interest rates; while decreased risk or perceived decrease of risk, lowers them. The real risk of a situation is sometimes hard to gauge though. That’s why interest rates vary so much.