Interest
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Banking basics
A recap of a few things you’d think financial professionals ought to know
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Interest
/ˈɪntrɛst/ (n.)
The return a fellow pays another from whom she has borrowed money for a fixed term. Usually articulated as a percentage rate for the length of the commitment and calculated on the amount borrowed.
In common parlance interest can be fixed, floating, or variable — limited really only by the imagination of the borrower and lender. But as we will see, whatever the formula for its reset over a longer term, over the minimum commitment period, all interest is fixed.
Interest periods
All lending is has a minimum “commitment period” — being the shortest period to which a lender commits to hold a fixed interest rate. This we might call an “interest period”. An interest period can be as short as one day and as long as — longer than — five years. The interest payable for the minimum commitment period is fixed and then reset at the start of each interest period. If it wishes to repay the loan before the end of an interest period the borrower must pay “breakage costs”.
Terms and rolling facilities
This interest period may differ from the loan’s term: the period over which the lender commits to not recalling the loan. Where term and the interest period are equal, we call it a fixed-rate loan. Interest is fixed at the outset of the loan and fixed for its duration.
Where the term comprises multiple interest periods we call it a floating rate or variable rate loan. Interest is recalculated and reset at the start of each interest period.
In both cases, the term is finite: at the end of the term the loan “matures” and the money becomes due for repayment. There is no expectation of carrying on.
Other lending arrangements have interest periods but not a finite term. These we say are “rolling” facilities: unless the lender asks for its money back at the end of an interest period, the loan “rolls over” and renews, for a new term of the same length at an adjusted interest rate reflecting the changed market interest rate over that period.
Bank deposits are classic “rolling facilities”: they do not have a stated maturity; you can have your money back at any time by asking for it. Facilities with short interest periods tend to be rolling arrangements: why would you bother lending money on fixed terms for a day? Longer term interest rate commitments tend to have a term.
A third type is a combination of a rolling facility and a loan repayable at term. These minimise breakage costs for borrowers but guarantee funding from lenders. The borrower can repay the loan without breakage costs at the end of each interest period; the lender commits to lend until its final maturity date. Here the loan has short interest periods where it automatically rolls and resets interest, until the final stated maturity for the loan. We call these “floating rate term loans”.
A bank deposit, for example, is a rolling loan with an overnight term. You can have your money back with accrued interest and no breakage costs daily. So is commercial paper: it is a form of very short-term debt security (which redeems, the general expectation in the marketplace is that the same investors will roll their investments into a new issuance commercial paper From the same issuer and on the same terms.
A floating-rate term loan that resets each month is, in essence, a series of rolling month-long fixed-term loans with an end-point of the final maturity date. The borrower can repay the loan with accrued interest and no breakage costs monthly, though the lender is expected to stay to the stated maturity, it . If you want your money back intra-month there will be a breakage cost, but only for the unexpired portion of the loan.
So, in a sense, all interest is fixed interest.