Interest rates are the cost of money. Remember that money serves as a medium of exchange, a store of value, and an accounting unit. Currencies backed by governments are usually considered money (dollars and euros) and used to standardize prices. In the modern world, everyone is either a borrower or a lender and often we are both. For instance, many have a home mortgage where they are a borrower and at the same time a lender with either a savings account or investment portfolio. The key to a successful economic life is to borrow at a lower interest rate than what you earn as a lender or investor. The earlier you learn and practice this axiom, the more prosperous you will be.
Some points clarify why this is crucial to a successful business, government, and personal life. Have you ever wondered why “the rich get richer, and the poor get poorer”? A major explanation comes from interest rates. As previously discussed in past columns, short term buyers usually pay a higher price, and this is especially true with respect to the cost of money (interest rates). A credit card enables one to borrow money at will but usually at a high interest rate. And pay day lender customers are even more stressed and short term borrowers. On the other hand, the “rich” are lenders/investors and interest rates (especial high ones) work in their favor. The “rich get richer” because they are lenders while the “poor get poorer” because they are borrowers. In the first case, interest rates increase wealth while in the second case, interest rates decrease wealth.
Another issue related to interest rates is timing. Human beings are constrained by specific time frames. My father was born in 1923 and his advice on interest rates was to “borrow as much as you could if rates were below 6%.” Of course, today, with rates for the best borrowers substantially below 6%, this might be a somewhat risky strategy but over a 96-year life in the United States, it proved to be very beneficial for my father. Getting back to credit cards, the most important advice is to pay 0% if possible. And never pay over 10%. This simple strategy will save a person thousands of dollars and enable them to concentrate on the second prong to success, lending/investing.
Investing is not a difficult concept to master when one understands the power of compound interest, which as a mathematical concept is just exponential growth. Learning and applying this financial principle is probably more impactful than almost any other economic concept. You have probably heard the story about the 20 year-old who starts saving/investing $100/month at an interest rate of 6% vs. a 30 year-old who saves $100/month at an interest rate of 8%. The 20 year-old has $275,600 at 65 while the 30 year-old has $229,388 at 65. So starting as soon as possible and choosing a saving/investment that generates reasonable returns (interest rate) over a long period of time is the take away of today’s lesson.
Steve Turner is a professor of Agricultural Economics at Mississippi State University.
