Understanding Interest Rates
SEOUL, South Korea — When trying to understand interest rates, its best to step back first and take a look at it as a whole. So, let’s start with the big picture. Either the central bank or the national government in each country is responsible for printing money and controlling the country’s interest rate. In Korea, it is the Bank of Korea (BOK), in the US, it is the Federal Reserve or “The Fed.” Around the world, there are approximately 170 central banks that manage their country’s economies and set interest rates according to the needs of the economy at that time.
The interest rate is but one tool in the toolbox of monetary policies that the central banks use to stimulate either consumption or investment and to manage inflation. The policies implemented by these central banks have far-reaching effects on the global economy and therefore also on your own personal finances.
A low interest rate makes the cost of borrowing money cheaper, which makes borrowing money more attractive, which in turn makes people want to borrow money to make investments, which stimulates growth for the economy. Or so the theory goes. Let’s say you want to start a business or buy a house, but you need some initial investment capital or a mortgage loan. You’ll most likely need to borrow these funds from a bank. If the bank is offering a low interest rate, you’ll be more inclined to take out a loan and go forward with that investment.
But, if the bank quotes you a high interest rate for your loan, you’ll be far less inclined to go through with your investment plan because the cost of borrowing that money is too high. Instead, you might just decide to wait until interest rates go down until you take out that loan. Meanwhile, since interest rates are high, you might invest the money that you already have because you can earn high interest rates instead of paying them. A high interest rate makes the cost of borrowing money higher (more expensive), which in turn makes saving money, rather than spending money, more attractive.
But, the central bank’s announced interest rate is not the actual interest rate you will be quoted when you try to get a loan or when you open a savings account at your local bank. The interest rate that your bank offers or charges you is based on the central bank’s announced interest rate though, so it’s very important, but in an indirect way.
When you open any type of savings account at a bank, you earn interest on whatever money you deposit there. The interest rate that your bank offers you is based on the central bank’s announced rate. So, in countries where the central bank announces a high interest rate, the interest rate you will pay on a loan, or earn on a savings account will also be high. And it follows that the opposite is true in countries where the central bank announces a low interest rate.
One important point to note is that the interest rate you receive on a typical savings account is most likely a simple interest rate that is applied per annum (per year). A common misconception is that your interest is calculated and added to your principal each month, and then the next month, the interest is calculated again based on your growing principal. But, this is not the way a typical savings account works. However, most banks do have this type of compound interest accounts available if you ask (but you will likely earn a lower interest rate to offset those compounded earnings).
Consider the current investment environment where you live. What is the interest rate in your home country? Is it low? Your central bank is likely trying to stimulate investment. Is it high? Your central bank might be trying to curb inflation. But what does this mean for you and what should you do with your money?
Right now the BOK’s announced rate is 3.25% and the Fed’s announced rate is close to zero (and is expected to stay there through 2013). Based on this very simple comparison of 2 country’s central bank’s announced rates, it is easy to see where you would probably get a better rate on a loan and where you would more likely rather have your money deposited in an interest-earning bank account. However, it is important to note that this simplified example does not take one very important factor into account: inflation. Double-check that the country’s inflation rate isn’t wiping out all of your hard earned interest earnings!
Of course, this is a simplified explanation and there are several other factors that can affect a central bank’s movements of the interest rate and its indirect, yet powerful, effects on your finances.
Michelle Farnsworth is an 8-year resident of Korea who is currently the Foreign Client Relationship Manager at the Shinhan Bank Seoul Global Center – the first and only bank branch in Korea that is exclusively dedicated to serving foreigners and foreign companies. Please visit the “Shinhan Bank Seoul Global Center” on Facebook for more information or contact Michelle directly at [email protected].
Please note that the banking information provided in this article is based on Shinhan Bank policies and may not be applicable to all banks in Korea.