ShmoopTube

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Finance a la shmoop how are interest rates determined? mm-hmm...so imagine

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this some nice stranger out there just pre-approved you for a credit card [Person thinking about credit cards]

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groovy looking over the paperwork you got in the mail however it appears

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there's a 20% interest rate attached awesome ish except you have no idea what

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an interest rate is why it's that percentage or who set it at 20% well

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congratulations you're about as clueless as the typical 35 year old these days [Woman walks into lamp post holding credit card]

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but here's the lowdown for every thousand bucks you borrow on that credit

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card you'll be paying two hundred bucks a year to rent that money and you'll

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continue to pay that every year until both the principal and the interest of

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your loan are paid off well there are two elements to an interest rate one [Elements to interest rate appear]

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element is the economy the world's interest rates are generally set by

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governments seeking to either add fuel to the flame of the economy by lowering

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rates and making money cheap to borrow so people spend and hire people or they're

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trying to suck oxygen from its thirsty gaping maw so that the world's economies

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are relatively stable and inflation is under control meaning they make the cost

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of borrowing money high so the pricing doesn't get out of control and that's

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for a different video and we'll get to that later...when economies are weak

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the government lowers interest rates right they're hoping to encourage people

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to spend money greenlight new projects hire new bodies [People shaking hands]

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do stuff with their dough low interest rates on credit cards are generally a

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good thing for consumers seeking to buy tchotchkes like earrings and belly rings

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at a mall so that is if your credit card only charged you 2% a year in interest [Interest of credit card formula appears]

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well that'd be 20 bucks a year to rent that grand and with cheap money

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available to you well you'd be happy to buy more belly rings on credit well

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things work in the opposite direction as well when economies get too hot and

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inflation runs out of control governments seek to cool things down by

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raising the cost of money when inflation is very high bad things happen generally

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to old people which sucks because we love the [Old man falls over]

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guys they always have butterscotch candy take for example someone who lives on a

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pension that pays them say 3% a year like it's all in bonds because they have

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to be safe they can't take stock market risk so they only get 3%

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well if inflation skyrockets and it's 10% a year well in a very short time

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period they're spending dollar buys only half as much as it used to and while

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then you can find these people living in a station wagon from the 70s parked on [Old man and woman sitting on chairs]

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your local curb got it so if inflation is 10% they're only getting 3 they're

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losing 7 percent of their buying power every year so that was the capital

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markets price of money I.e what's the price the government

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sets for the cost of its best customers to borrow money yeah that's the Fed

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that's kind of how they price lending money to banks all right well who are

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the best customers Google, Bill Gates that nun who just won the lottery [Nun appears in church]

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but that doesn't tell the whole interest rate story here why would you be charged

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20% interest on your credit card and Bill Gates only 3% one word risk if

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you're Bill Gates who's got like roughly a bajillion dollars and you're taking a [Bill Gates relaxing in a chair]

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loan for a short duration and have a long history of paying back your debt

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well you're a low risk to pay back that thousand dollars bill borrowed to put

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his bellybutton ring in at the mall and a bank can afford to charge him a small

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interest rate because it's so likely they'll get paid back whereas if you're

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just some bum named Gil Yates no relation obviously and you have five [Gil standing at a bus stop]

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dollars to your name and are a huge flight risk well a bank is probably not

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going to be too excited to offer you any loan at all and if they did it would

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feature an extremely high interest rate to make up for the risk of you not

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paying them back right if you were the bank you'd probably do the same thing

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so who's the magic wizard behind the curtain who sets these things in the [Interest rate appears from out of magicians hat]

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first place and how does that work well financially the US is still the center

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of the world the Fed is the American vehicle which

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sets the price to banks for borrowing money the Fed, the Fed yeah it sounds

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kind of kind of like big shot there right well structurally banks might pay

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1% to the government to borrow money and then they might mark up the price of

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that money to 5% make 4% spread between the bid and the ask

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price of the debt that they basically buy from the government and then resell

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to people like you and me... in English you bet say a bank takes a million dollar

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loan from the Fed it'll pay $10,000 a year in interest to the Fed for [Interest payment calculation appears]

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borrowing that money if it turns around and loans money to Joe the Plumber

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a million dollars for his parts distribution business charging him 5%

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per year well then Joe pays the bank 50 grand a

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year to rent that money and the bank shows a gross profit thereof $40,000 a

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year just for kindly Joe that's 50 minus 10 you know some heavy calculus there

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now while all of this might sound like the financial gravy train is not that [Gravy train of money goes by]

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simple Joe the plumbers business well like that kind of business goes bankrupt

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all the time and when that happens banks don't get paid back the million bucks

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they loaned Joe sometimes they get zero the banks are however still on the hook

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for the million dollars they borrowed from the American federal system if the

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bank doesn't pay back the Fed well they basically all go to jail and get

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tortured in Guantanamo or something like that oh wait we don't torture anymore do

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we oh we do all right then well then you

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don't want to default on the Fed so anyway that widespread of 4% has to cover

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a lot of deadbeats who don't follow through on their promises to pay back

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the money they borrow that's how it works in the US and most Western [Western countries highlighted on map]

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countries have more or less the same system the numbers may seem small to you

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but over time they really add up if you borrow $10,000 at a 20 percent

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annual rate and it takes you ten years to pay off that money well your total

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interest would be and strap yourself in there here's the math it's ten thousand

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times the quantity one plus 0.2 which is the 20% there to the tenth power that's

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how you do the math there so what's 1.2 to the 10th which reflects the

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compounding of that interest rate for about ten years well it's about 6.2

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how do you get the math well you multiply that number by 10,000 which

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revealed that a 20% interest rate on a 10-grand loan for 10 years cost you

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about 62,000 big ones 10 grand it really cost you 62... [Bill gates appears]

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compare that to Bill Gates who can spend $10,000 on a cheap card costing 3% and

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doesn't pay it back for 10 years well here's the difference the cost of

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renting that 10 grand for 10 years at 3% well it's about 1.35 and yes Bill's

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cost of renting that doe for 10 years 13.5 grand vastly cheaper because

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well Bill is a vastly safer bet to pay back his debt than you are as for that [Interest rates for Bill and Joe appear]

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20% rate on your new credit card well it sounds steep but it's sadly pretty

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average just be sure to pay it off each month because if you get way behind in

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your payments well, the magic wizard behind the curtain isn't going to swoop

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in to save you sorry just keeping it real

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