The total cost of borrowing money
In a free economy, the interaction between those who can supply funds and those who need to borrow money determines the cost of money, which is, in effect, the rate borrowers pay to lenders. For debt, this rate is called interest rate. For equity, it is called cost of equity and consists of the dividends and the capital gains that shareholders expect.
The cost of money is affected by five fundamental factors that influence the rate at which one can borrow on a certain period. In particular:
- Production Opportunities
Production opportunities are related with the capacity to turn capital into benefits. For instance, if a company raises capital, the expected rates of return on its production opportunities will determine the expected benefits. If a student borrows money to finance his/her education, the expected benefits are determined by expected higher salaries from future employment. Therefore, the production opportunities are subject to different expected benefits that determine the upper limit on how much borrowers pay to lenders.
- Timing of Consumption
Lenders can use their current funds for consumption or saving depending on their expectations. If they expect that future consumption will be higher, they prefer saving today and give up today’s consumption. If they have a strong preference for immediate consumption, it means that they expect that today’s interest rates are higher than future interest rates and therefore, they prefer trading current consumption for future consumption.
- Risk
If the expected rate of return on an investment is high, it means that the investment is risky and that investors need to take an extra risk in order to enjoy an extra return. This increases the cost of money.
- Inflation
Inflation is another factor that affects the cost of money. For instance, if an investor earns 10 percent on an investment, but inflation causes prices to increase by 20 percent, it means that the investor cannot consume as much as he/she could when the money was originally invested. If expectations were for an inflation rate of 20 percent, then the expected rate of return would also be higher than 10 percent.
- Interest Rates
There is a price for each type of capital and these prices change according to supply and demand shift. For instance, short-term interest rates typically rise during market booms and decline during market recessions. This is explained as follows: when the economy is expanding and firms need capital, interest rates increase; when economy is shrinking and firms reduce the demand for credit, interest rates drop.
The interest paid on borrowed assets may be simple, which is calculated on the principal amount or compounded, which is calculated after unpaid interest is added to the balance due. Generally, the nominal interest rate (r) is determined by the risk-free rate (r*), which the rate that would exist on an inflation-free security plus the inflation premium (IP) that, in effect, wears down the purchasing power of consumers and lowers the real rate of return of investments. However, there are also other premiums that affect the interest rate levels such as the default risk premium (DRP) that reflects the possibility that the borrower defaults on debt, the liquidity premium (LP) that reflects the possibility that some securities cannot be liquidated at a reasonable price and the maturity risk premium (MRP) that reflects the fact that some bonds are exposed to a significant risk of price drops.
Overall, the total cost of borrowing money is subject to many factors and not just the interest rate. A variety of monetary and non-monetary costs are involved in the process and should be taken into consideration for determining the real cost of borrowing.
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Article Source:http://www.articlesbase.com/loans-articles/the-total-cost-of-borrowing-money-1230675.html
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