Anybody who lends money to another accepts a risk: that the borrower may fail to pay back what is owing. Moreover, the lender cannot use the loan amount during the term of the loan.
So why should anyone lend money?
It’s simple – nobody wants to lend money for free! If you borrow money from the bank, you have to pay interest. If you give money to the bank as a deposit, you will receive interest for it.
Broadly speaking interest comes in two forms:
this is the interest the bank pays you on the money in your current account or savings account.
this is what you have to pay when you borrow money from the bank. Business enterprises also pay interest on loans they take out.
The bank does not simply hoard the money in its current accounts and savings accounts – it uses the capital to extend credit to companies and individuals in need of loans. The bank charges higher interest rates on credits than it pays on the deposits in its accounts.
The difference between the two rates is the bank’s profit, which it uses to fund its operations. Acting as a financial intermediary between savers and borrowers is one of the core business fields of a bank.
Loans are taken out by many people. How much this costs – that is, what the interest rate is – depends mainly on the risk that the borrower might not repay it.
The larger the loan amount and the longer its term, the higher the interest rate usually is. The reason behind this is that such loans are a greater risk for the bank.
The more the bank trusts that the borrower will be able and willing to repay the loan, the less interest will be charged. Things like a stable income or owning one’s home add up to a good credit rating, and a bank will charge borrowers with good credit ratings lower interest rates.
In operating their credit business, banks also take into account the interest rates at which they themselves can borrow money from other banks and from the European Central Bank (ECB). Central banks set the key interest rates as appropriate in terms of monetary policy.
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