What is an interest rate, really?
Three courses in, you can read a market. This course adds the weather system above it — and the first instrument on the panel is the interest rate.
Money for rent
An interest rate is simply the price of borrowed money. Lend €1,000 for a year at 5% and the borrower returns €1,050 — the extra €50 is rent. Like any rent, it isn't arbitrary. It compensates the lender for three things:
- Waiting — money you've lent is money you can't use. Patience has a price.
- Risk — the borrower might not pay it back. Shakier borrowers pay more; that's why a startup's bond yields more than a government's (your Course 1 instrument-zoo knowledge, now with a why).
- Inflation — the euros coming back will buy less than the euros going out. Lenders demand compensation for the shrinkage (lesson 3 of the next unit makes this precise).
Rates are quoted in their own units and the news mixes them. A move from 4% to 5% is a rise of one percentage point, and also a 25% rise in the rate; the first phrasing is the one professionals use, because the second exaggerates every small move near zero. Smaller steps are counted in basis points: one basis point is one hundredth of a percentage point, so a cut of 25 basis points takes 5.00% to 4.75%, and 100 basis points is one full point. When this course says a gap is "a basis point or less", it means a hundredth of a percent. When a headline says "rates up 25%", check whether it means points.
One price, everywhere at once
Look around: your savings account pays an interest rate. Your mortgage charges one. Companies borrow at one, governments at another, and your credit card at a painful one. These aren't separate worlds — they're all rooms in one building, and the rents are related.
The anchor rate
The floor of the building is the yield on government bonds of the most trusted states — often loosely called the "risk-free" rate (nothing is truly risk-free; it's the least-risky benchmark available). Every other rate stacks on top of it: take the government yield, add extra for the borrower's risk, and you've priced most loans on Earth. When that floor moves, every floor above it moves too — which is why a single rate decision can shake every market at once, as the rest of this unit shows.
Try it now
- Find the interest rate your own bank pays on savings — and what it charges for a consumer loan. Subtract the first from the second: that spread, in percentage points, is the bank's business model written as one number, and it is usually wider than people guess.
- Now look at the rent on money at the safest end of the market. This is a yield, not a price, so a value of 4.674 means 4.674%:
Read the current level, then read where it stood five years ago. The rent on money is not a constant, and every price in every other course is quietly discounted against it. 3. Set the three numbers side by side — your savings rate, your loan rate, and the ten-year government yield — and subtract the yield from each of the other two. Two gaps, in percentage points, and their signs are the lesson: the government almost certainly out-pays your bank for the same waiting, while your loan costs several points more than the safest borrower on earth pays. Does that ordering match what waiting, risk and inflation would predict? 4. For the policy rate that anchors the short end, here is what two central banks have actually set: the Fed's target range, then the ECB's three rates.
Recall the Course 1 lesson on bonds and explain in one sentence why a riskier company's bond must offer more than any of these. 5. Say it out loud: "an interest rate is the rent on money — waiting, risk and inflation set the rent."