Lesson from the past hints at the future of interest rates

It has been more than 45 years since the two of us sat in free-market economist Vervon Orval Watts’ economics class at Northwood University. He noted an interest rate is the incentive or reward charged by a lender of credit or money. For the borrower, it is the amount they are willing to part with or pay to gain cash or credit.

An interest rate consists of three parts. They are the time preference premium, debtor risk premium and inflationary risk premium.

The time preference premium is the original reason for loaning money. The average TPP portion of an interest rate is between 0 and 2 percent. It represents a borrower’s time preference to have a good, service or asset today and pay extra via the interest rate, rather than waiting until able to pay in full. When a time preference is 0 percent, the borrower is willing to wait.

The debtor risk premium is inversely related to a customer’s credit rating. The debtor’s risk premium portion of an interest rate is usually between a half percent and infinity. A person with a high overall credit rating usually receives a low DRP, while a person with a low credit rating receives a high DRP — resulting in a higher interest rate on future loans. Fraud and other criminal activity also increases the DRP.

The inflationary risk premium correlates to the rate of inflation. As inflation increases, the IRP portion of an interest rate goes up, as does the overall interest rate. When inflation declines, so does the IRP and overall interest rate. The IRP, in theory, is between 0 percent and infinity. Pre-2021 saw 30-year mortgage interest rates below 4 percent and automobile loans for those with low DRPs at or near 0 percent.