Interest As Backbone of Modern Economy - Part 1

by Shafi Farooq
http://mywebsiteworkout.com/personal-finances/

In modern world, especially the Western world and Japan, interest rate is considered the backbone of modern finances and that includes your family finances as well. It affects and impacts us all in every walk of life. Individuals and families ought to understand its importance.

The interest comes into play when we borrow money or lend money. Everyone is affected when the interest rate goes up or when it comes down. This backbone of the economy is controlled by the central bank of a country. In the U.S., it is called Federal Reserve Bank.

I have divided this article in multiple parts. So each part is published here separately. I have attempted to explain what interest rate is, why it is changed and what effect does it have on us all.

You are a borrower and a lender
You are a borrower when you borrow money from an individual like a friend or relative. In probably, 99% of cases or maybe more, there is no cost to you. You pay back the principal amount at some time in the future the two parties have agreed on beforehand. Your lender here is not in the business of making money so there is no interest attached with the principal when you pay it back.

You borrow money from an institution such as your neighborhood bank which charges a certain percentage of your loan on top of the principal you have borrowed. The reason they charge you extra because they are in the business of making money. That's their bread and butter and it is called the cost of capital or interest.

If you think about it, in Western world at least, interest affects every part of your financial life. When you become a borrower, these interests have direct impact on your household budget. You pay interest on a home mortgage, auto loan, or credit card bill.

You are a lender
If you are a lender, interest rates determine a portion of your income. Now how can you be a lender and make money? You lend money to a friend or relative, you don't charge interest on the loan. They didn't charge you so why should you?

You may not think of yourself a lender, but if you own bonds, you are, in essence, lending your hard-earned money to the U.S. government - through Treasury bonds and U.S. Savings Bonds, state and local governments and agencies - via municipal bonds. You can also lend money to businesses - through corporate bonds. And you know what? They pay you interest on the money you buy their bonds with. So you make some extra money on the principal that you lent to others.

There are corporate bonds that you don't make whole lot of money in interest. For example, at times, Lehman was the darling of Wall Street but Lehman, of course, filed for bankruptcy recently - so those bonds may return something, but not as much as people thought they would get.

You think you are neither?
Well! think again. Even if you are neither a borrower nor a lender, the cost of borrowing money is built in almost any product or service you buy. That's why interest rates are a key indicator of the health of nation's economy. It has a direct or a definite indirect impact on your financial life. For example, tigerdirect.com sells computers and a whole lot of other items. They have merchandise in inventory sitting in storage somewhere. They have borrowed money from banks in order to buy parts and systems. They pay interest on that borrowed money. And you, as customer, must pay a part of that interest when you buy that merchandise. Similarly, tmicell.com is such a company where they sell cell phones and accessories. They charge you the price that includes the interest on the money they borrowed from banks.

In the next posts, I will take a closer look at how interests work.

Article submitted Saturday, November 14, 2009 & read 72 times.

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