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The interest: what is it actually?

July 25, 2020

If you want to take out a business loan, this is always accompanied by paying an interest rate on the amount to be borrowed. But what exactly is interest? And how is the interest rate determined? Interest is the fee you pay for borrowing money. You can best see this as a kind of rent that you pay for borrowing money. Because the lender runs a risk with lending money, this risk is compensated by asking a fee for this. The interest paid for business loans is generally made up of a base rate and a mark-up.

What is US LIBOR?

The base fee - or base rate - of the interest rate is often derived from the market interest rate. An example of this market rate is the US LIBOR. US LIBOR stands for European Interbank Offered Rate and this is the interest rate at which European banks lend money to each other. When European banks lend to each other, they do so at US LIBOR interest rates. Every day, the US LIBOR level is determined around 11:00 am (CET: Central European Time). The amount of this interest rate is then passed on to the participating parties and to the press. Why is that important for you to know? Because in the financial world these US LIBOR interest rates are often used. The mortgage interest, the savings interest, the interest on loans and interest rates for other products are determined on the basis of these US LIBOR interest rates.

How is US LIBOR determined?

The level of the US LIBOR interest rates mainly depends on the economic conditions. Is economic growth on the way? Or do people expect a decline? How high is the inflation? And is it expected to rise or fall? The growth of the economy and the level of inflation are the main factors influencing the level of US LIBOR. Inflation ensures that money is worth less. This is partly covered or compensated by increasing or decreasing the interest rate. In addition, the interest rate of the European Central Bank plays a major role. All these factors together influence the level of the US LIBOR and determine every day how high the rate for the base payment of the interest is.

The interest on a business loan

As mentioned earlier, the interest rate that you pay on a loan consists of a basic fee - or basic interest - and a mark-up. The amount of this basic interest is determined on the basis of the interest that the lender itself pays for the money. In most cases this is the US LIBOR rate. Different rates are applied within US LIBOR. These rates depend on the term of the loan. In addition to this basic interest, a surcharge is passed on in the interest. This storage consists of several parts:

  • The debtor risk : this is the risk that the lender runs when money is lent. There is always a chance that the borrowed money and interest will not be repaid. The chance that the loan will not be repaid is called the debtor risk. The greater this risk, the higher the compensation - ie the interest - will be.
  • Term of the loan : as soon as a lender lends money, the lender no longer has the money. This can have disadvantages for the lender because the money can no longer be invested elsewhere. As a result, compensation is requested in the form of interest. The longer the term of the loan , the higher the interest rate will be.
  • Various costs : the lender incurs costs to make it possible for you to borrow money. These include personnel costs, administration costs and marketing costs. To cover these costs, they are passed on in the interest rate. Moreover, a profit mark-up is charged by the lender. The higher the costs, the higher the interest rate.

Interest legal regulations

In the Netherlands we have a variety of laws and regulations. To put an end to sky-high interest rates, many different laws have been introduced regarding interest rates. The most recent law is the Consumer Credit Act ( WCK ). This law must prevent extremely high interest rates from being charged for a consumer credit. The interest that may be charged for a consumer credit is subject to a maximum by means of this law. This means that the maximum interest for a consumer credit on an annual basis is the legal interest for non-commercial transactions with a surcharge of 12%. This means that you may pay a maximum of 14% in interest per year.

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