Interest Rate / Bank Interest rate
Origin of Interest Rate.
Adding of interest to deposit (interest rate or bank interest) - is one of the oldest and the most curious human inventions. It is assumed that people started charging interest (interest rate) on invested capital in the ancient times, together with money appearance. Though it was known that one could borrow not only money. When barter was common, first credits were granted in grain. For instance, one farmer lent the other with a basketful of grain and demanded a bigger basket in return.
Activities of lenders (people accommodating with a loan) made the " bank interest " one of the most important phenomena in the modern world and the most disputable issue in the past. Collection of interest became known to the Ancient Greek philosophers and their condemnation influenced strongly the attitude toward interest in the Middle Ages both in Europe and in the Islamic world. Arguments of the sophists had a peculiar logic. Money, they said, had no intrinsic value, since it had not existed during Creation of the World. Since it has no intrinsic value, the owner loses nothing when he lends money. Therefore, he cannot lay a claim to investment revenue. So, it was impossible even to think about any interest rate at all.
In the eyes of the Church, the money lenders were doomed to endless condemnation from the very beginning, so they had to invent new crediting patterns in order to avoid direct loans. The most successful were Italian money-changers of the 14th century, called the bankers (from Italian "banco" - a table). Instead of direct loans, they offered bills of exchange. Such transaction was a sale of one type of money for another to be paid at agreed time. At that time Italy and France had strong economic relations. A merchant, who needed money, went to an Italian banker to borrow cash in one currency, and then both of them signed a bill of exchange, according to which the merchant agreed to pay back a little larger sum in another currency in France.
New Italian bankers' money boosted commerce development due to fast transportation. In 1338, transportation of coins from Rouen (Northern France) to Avignon took three weeks. There always was a risk that money would be seized or stolen by the people, hired for its transportation. A bill of exchange needed only eight days to travel, and even if stolen, the thief could not use it. In spite of its cost (the interest rate was about 8-12%), the bill of exchange was cheaper than the cost of armed escort for transportation of gold and silver coins or bars.
Banking business appeared during the Italian Renaissance and was not quite respected in the beginning. Bankers tried to become distinguished citizens by increasing their wealth, aristocratic titles and high ecclesiastic ranks, but they managed to receive recognition only after mass services provided to the lowest classes. It became possible with discovery of immense riches of America. People, traditionally dependant on money (soldiers, artists, lawyers, doctors, etc.), were more willing to draw salary than to get commodities (dwelling, food, alcohol, salt, etc.) for their services. Even prostitutes and innkeepers did not want to be paid with food and goods. They also wanted gold or at least silver coins. This is how the history of interest rate began.
Redistribution of wealth gave an impulse, especially in the 17th century, to development of the middle class merchants. In their turn, they gave birth to new trades, related to money. With development of the banking business, there appeared brokers, who specialized in purchase and sale of everything - from real estates to shares. Banks needed more and more money, and by that time a system of bank deposits had been established, so that anyone could become a moneylender and live on interests.
Modern market of banking deposits.
Today, all stocks in the bank (deposits), made in order to preserve and make money grow, can be divided in two categories:
- demand deposits (or non-fixed deposits) - these are deposits, which can be demanded by the depositor at any moment;
- time deposits (deposits, accepted by the bank for a fixed period) - these are deposits of money in the bank for a certain period, for example, for one year.
Banks pay very low interests on demand deposits (usually, the interest rate is about 0.1% per year) or do not pay interest at all. Some banks with century traditions of servicing big and regular customer even charge them for keeping their accounts. In some degree, this is because the banks undertake maintenance of payment transactions of the clients. There is another explanation: demand deposits cannot be used for a long period by the bank. Moreover, accepting deposits, the banks assume certain risks: economic, political, legal, inflation, etc., as well as expenses on bank employees, lawyers, tax authorities, etc.
The second group of deposits is formed by "time deposits". The banks accept such deposits for the period of at least one year. In this case the depositors have a higher interest, depending, as a rule, on the time of deposit and the deposit amount. So, the banks can administer these funds for a longer period of time.
The interest rate also depends on the deposit currency. This is because economies of the countries-owners of the currency are at different cyclical phases; their governments may pursue different economic policies of money appreciation or depreciation.
It should be noted that reliable banks, as a rule, offer low interest rates on deposits of their clients. In 2004, the leading banks of Lichtenstein offered their clients 1.2% in USD and 1.55% in EUR on deposits from 100,000 EUR. In this case, the low interest rate is compensated by high reliability of the bank and high quality services.
Today, the biggest trustworthy banks offer from 1 to 8% annual interest rate on deposits over 50,000 USD/EUR. It is in line with inflation rates in developed countries (2-6% of the weighted average cost of USD/EUR) and profitability index of legal business in European countries (7.5-15%).
Interest rate calculation.
Currently, all over the world the interest rate is calculated according to common standards. Money amount (M) to be received by the client at the end of the deposit time can be calculated according to the following formula:
М = D * (1 + r/100* t/360)
- D - deposit amount,
- r - interest rate of the bank,
- t - time of deposit in the bank (in days),
- 360 - number of days in the year. In the banking world it is assumed that all months have 30 days.
For example, if we deposit 20,000 USD for 6 months at 8% per year, at the end of the deposit period we will have:p>
М = 20'000 $ * (1 + 8%/100 * 180/360) = 20'000 * (1 + 0,08 * 0,5) = 20'000 * 1,04 = 20'800 $
The said formula is suitable only for those deposits, for which interest is added once - at the end of the deposit period or in the beginning of the year. However, there are deposits, where interest is added several times, for example, monthly. In this case the interest rate is quite complicated. If interest is charged every 30 days, the profit is calculated as follows:
M = D * (1 + r/100*30/360)^(360/30),
For example, if we deposit the same 20,000 USD for 12 months at 8% per year with interest added each month, at the end of the deposit period we will have:
М = 21'660 $.
Thus, the shorter is the period of interest addition to the deposit, the higher profit the client receives in the end.
Virtually, banks never add composite interest for a period shorter than one year. That is why it makes sense to consider composite interest on bank deposits only if deposits are made for several years.
Interest rate in brokerage companies.
Originally saving operations were concentrated in banks only. Today not only banking institutions are involved in the thrift industry. Deposits in brokerage companies for sale/purchase of various financial assets may also have a saving nature. If the broker's deposit has available funds, the broker may use some of them for his needs, e.g. to allocate in international funds or invest in government securities. For such an opportunity, the broker may add interest to the client's deposit only on free margin, not involved in financial operations. This way of adding interest to deposit allows to keep the client's funds safe and to increase profitability of the broker company business. Furthermore, profitability of the brokerage company usually is much higher then the average bank interest rate, so, the adding of interest to deposit can be considered as a partial compensation of the commission paid by a client. Free margin may change every day, so the interest rate is calculated at the end of the day and is consolidated on a special account. For this account the charged interest is passed to the client's deposit for the whole month in the first days of the next month.
The brokerage company usually offers different interest rates and trade terms, depending on the client's preferences. For example:
- Commission - 0,015 %, SWAP - 1 pip, Interest rate - 3%;
- Commission - 0,03 % , SWAP - 0 pip, Interest rate - 6%.
- The first variant (with a lower interest rate) will be preferable for those clients, who close many transactions and do it frequently. For them a lower commission is the most important.
- The second variant (with a higher interest rate) is more profitable for strategic investors. They are more interested in a higher interest rate, since their transactions are rare. Additionally, the absence of a fee for transfer of a transaction for the next day (SWAP = 0) allows making cheaper transactions for a long period.
Additional conditions are set to receive interest by brokerage companies:
- To add interest to the deposit, the client has to make at least one transaction with any financial instrument offered by the brokerage company. This is because if the client opens a deposit and makes no sale/purchase transactions, interest charge on his account will be identical with the bank deposit. But the brokerage company is not a banking institution and cannot formally add interest only on the basis of receipt of funds.
- Interest is added every day to free margin, and it is necessary that its amount is not less that the level established by the brokerage company (Trigger). For example, if Trigger = 2,500$, this means that if at the end of the day free margin is lower than 2,500$, interest is not charged for this day.
Summary of interest rate addition advantages in brokerage companies.
The principle differences in interest addition on deposits in the brokerage company from bank deposits are:
- Interest is added every day, not at the end of the deposit period;;
- Interest rate is composite, since interest is entered to the account every month;
- Realized profit is automatically reinvested every day, and interest is added to it at once;
- Money can be withdrawn from the deposit at any moment, and added interest is not lost;
- The deposit can be increased at any moment and interest for this day will be added according to the new amount;
- Deposits in the brokerage company can be opened not only by stock jobbers, but also by clients with a less risky investment strategy.