Interest — the price of money
What are interest rates? - The definition
interest represent a fee that is charged for borrowed or invested money. Anyone who borrows money from a bank pays a type of rental price, interest. This interest rate is the result of a combination of different factors: processing fee, risk premium, liquidity premium and inflation premium. At the same time, banks also pay interest to customers who invest their money in overnight money or savings accounts — these are so-called credit interest rates.
Why are interest rates important?
Interest rates have an essential function in the economy: They define the price at which investments can be made. The National Bank therefore lowers interest rates whenever possible in order to stimulate the economy. It only increases this if there is a threat of inflation (an excessive expansion of the money supply).
The different types of interest and their functions
Here is an overview of the most important interest types and their function:
- Debit interest: These are due when borrowing. The borrower pays borrowing interest in return for the borrowed capital.
- Credit interest: Customers who invest capital in an account receive credit interest as a reward for their funds.
- Nominal interest: The pure interest rate without further fees and costs.
- Negative interest rates: When raising money is high, banks rarely charge negative interest rates, which means investors must pay for their assets.
- effective interest rate: This includes all costs of the financial product, i.e. processing fees, agio/discount and other fees.
- compound interest: Here, interest earned is repaid, which causes the so-called compound interest effect.
- overdraft interest: Due when a current account is overdrawn in excess of the agreed overdraft facility.
- Overnight interest rates and fixed-term deposit interest: Interest that banks pay out on invested amounts in overnight or fixed-term deposit accounts.
- Key interest rate: The most important reference interest rate at which banks can refinance themselves from central banks. In Switzerland, this is provided by Swiss National Bank (SNB) defined.
How is the interest rate calculated?
The following formula is used to calculate interest on a loan:
Monthly interest = (loan amount × interest rate)/(100 × 12)
The loan amount refers to the part of the loan that has not yet been repaid. Since the amount of debt decreases as a result of ongoing repayments, the interest percentage is also steadily declining.
Interest rate limits in Switzerland
In order to protect consumers, Switzerland sets maximum interest limits: The maximum interest rate for cash loans has been 11% since May 1, 2023, while overdrafts may not exceed 13%. However, this only applies to new credit agreements.
When is interest paid out?
Depending on the agreement, interest payments for fixed-term deposit or call money accounts are made monthly, quarterly or annually. Interest is also due on loans either monthly, annually or at the end of the contract period.
The compound interest effect
One of the most fascinating mechanisms is the compound interest effect. The following figure shows the compound interest effect graphically. Because this effect is self-reinforcing, it is known as exponential growth.
Compound interest effect graphWith an interest rate of 5%, it takes 14.4 years to double your capital. Whenever possible, you should reinvest the income in order to benefit from the compound interest effect.
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