In the first 10 tutorials we learned about return calculations in detail. Now, we are moving on to a new topic: interest rate calculations. Even though we may not notice it directly, interest rates have a profound impact on our daily lives.
Remember Tutorial #0, which was titled “Why do we invest?” We argued in that tutorial that investment is a sacrifice made from our current consumption to be able to consume more in future. The example we gave was saving more of your salary to have a better pension when you retire. We also claimed borrowing is the opposite. It is a sacrifice from future consumption to enjoy more consumption now. Typical example is purchasing a house with a mortgage. You start having the benefits of living in your own house now, but pay mortgage payments for years to come as a result.
Why are we repeating the subject of Tutorial #0 here? Because, what determines our choice between investment and borrowing is the market interest rate:
An increase in the interest rate causes us to consume less and invest more.
A decrease in the interest rate causes us to consume more and borrow more.
Let us explain these two important statements with an example. Suppose your monthly salary is $4,000. You have three options: (1) consume all your salary during the month, (2) consume less than your salary and invest the rest, or (3) consume more than your salary by borrowing. Options (1) is boring, so we’ll discuss options (2) and (3).
Let’s say the market interest rate is 2.5% per month. Then, if you spend $2,000 of your salary and invest the remaining $2,000 at 2.5% for a month, your dollar return will be: 2.5%($2,000) = $50, which you can spend on, say, a nice meal.
Now, suppose the interest rate suddenly doubles to 5% per month. Then, with the same level of investment, your dollar return would be: 5%($2,000) = $100. You could get two meals instead of one! Economists believe that the increase in the interest rate from 2.5% to 5% per month would actually cause you to invest more than $2,000 of your salary and consume less than $2,000 of it, since investing has become more attractive. That is, the increase in the interest rate increases both the dollar return on investment and the subsequent increase in consumption: $100 > $50, and makes us willing to cut a bit more from our current consumption to invest more, say $2,100 instead of $2,000.
How about if the interest rate plummets to 0.25% per month? In that case, if you invest $2,000 you will get 0.25%($2,000) = $5. You can’t really get a decent meal for that… Do you see where we are driving at? The interest rate fall would probably make you invest less, say $1,500 instead of $2,000, and spend more of your salary, $2,500 instead of $2,000.
But, how about borrowing? Let’s imagine you have a burning desire to lay your hands on a brand new, powerful laptop that costs $3,000. After spending $2,000 of your salary, you’re left with $2,000. This means you need $1,000 more if you want to buy your dream laptop right now. Well, you can borrow this amount now and pay it back with interest when you get your salary next month. If the interest rate is 2.5%, you need to pay back (1 + 2.5%)($1,000) = $1,025. On the other hand, if it has fallen down to 0.25%, you would pay back only (1 + 0.25%)($1,000) = $1,002.5, which is $22.5 less. Clearly, borrowing becomes more attractive when the interest rate falls down. Economists would argue that if the interest rate goes further down, say to 0.2%, you will borrow even more, maybe $1,100 so that you purchase not only a laptop, but maybe some software with it as well.
The bottom line is, interest rates determine our investment, borrowing and consumption choices. Increases in interest rates can make us invest more to enjoy higher returns and higher future consumption, whereas decreases in them can make us borrow more to enjoy lower cost of borrowing and higher current consumption.
Next tutorial: Simple vs compound interest
Previous tutorial: Arithmetic vs geometric average return
Next tutorial: Simple vs compound interest
Previous tutorial: Arithmetic vs geometric average return
excellent post!
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