What is interest?
Compensation for the risk 
Of lending money

Here’s a joke I didn’t make up:

Two young fish are swimming to school (ha ha) when they pass an old fish
“How’s the water boys?” Asks the old fish.
“Sure, fine, hi” say the younger fish, trying to be polite.
Once out of earshot from the old fish, one young fish turns to the other and says:
“What the heck is water?”

(Note: I got this joke from the late David Foster Wallace’s commencement address to Kenyon college from 2005, widely regarded as the greatest commencement speech ever).

The joke is supposed to be a critique of making assumptions and what happens when we don’t pay attention to, and try to understand how we connect with, the world around us.

In case you haven’t heard, interest rates have been a regular topic of financial news this year. I feel like I’m reading new content on a daily basis that discusses the Fed’s rate hikes, where they might go, what they mean for American markets, and what they mean for the world.

What no one has written about, that I’ve seen, is what interest actually is.

I’ve met people who ask me how to invest in the stock market so that their money can earn interest. Investing in the stock market does not generate interest. It generates capital appreciation. This is important to understand because capital appreciation is taxed differently than interest.

Earning capital appreciation on a stock investment means you may get to keep a different, and perhaps greater, percentage of that passively created money than if you had earned interest. This is because capital appreciation is taxed at capital gains rates. In terms of documentation, capital appreciation (or loss) is reported on its own tax form: Schedule D of your Federal Form 1040.

Interest, which is earned within savings accounts, bonds, and other interest-bearing instruments, will be taxed as ordinary income. There are exceptions to this, but the fundamental idea is that interest = ordinary income taxes. If you have more than $1,500 of taxable interest, this gets reported on Schedule B of your Federal Form 1040.

But this still doesn’t tell us what interest actually is.

Interest is compensation for the risk of lending money. The greater the risk, the greater the interest, and vice versa.

We can look at some examples to see this in action:

When someone puts their money in a savings account at their bank, how does the bank operate as a business model to turn this into a profitable relationship? They take those deposits and lend them out to people and businesses in the form of mortgages, personal loans, business loans, etc. Those entities pay interest to the bank and the bank earns money. The bank shares some of that income with their customers through checking and savings account interest.

This is risky for people depositing their money at the bank. What happens if they go to that bank later and ask for their money back and the bank can’t give it to them? The Great Depression happens, that’s what. The government created FDIC insurance and bank reserve requirements designed to prevent this very scenario from happening again.

As a result of these risk remediation efforts, putting money in a savings account at a bank is safe and liquid. This means it is freely available to use at any time. The money is so safe that you aren’t going to get very much compensation for the risk you are taking by making these deposits. For this reason, you can generally expect savings accounts to pay a only small amount of interest.

How can you do better than savings account interest? You can look at Certificates of Deposit (CDs). With these instruments, you are agreeing to not touch the deposit for a certain period of time, often one year. By introducing liquidity risk, the bank will compensate you a little more and you can expect to earn a modestly higher interest rate in a CD than in a savings account.

Moving along to bonds, these instruments are more complex than savings accounts, less liquid, and carry varying degrees of risk. This risk is quantified by bond ratings. Depending on which ratings agency is in play, bond risk is quantified by a letter-based code. For example, for Standard and Poor’s, a bond rated AAA is considered the highest quality, or “investment grade.” It carries the least amount of risk that the issuer will default on its debt, which would cause the investor to potentially lose his or her investment. For this reason, a bond rated AAA will generally have a lower coupon, or interest, payment than a lower-rated bond.

Lower-rated bonds are euphemistically called “High Yield” bonds. You might encounter bond funds with names like “Hootenannies’ High Yield Bond Fund” (disclaimer: as far as I know, this is not a real bond fund, and if there is such a fund, I make no recommendations about it). “High Yield” means the bonds within that fund have lower ratings.

To compensate the investor for buying riskier bonds, the issuers will pay a higher rate of interest. This entices risk-taking investors to forgive the riskiness of the issuer’s financials in favor of earning a higher rate of return on their money.

The non-euphemistic term for these instruments is “junk bonds.” A financier named Michael Milken helped develop the market for junk bonds before being sentenced to 10 years in prison and being fined somewhere between $200 and $600 million (depending who you read) for racketeering and securities fraud. So, there you go.

As a consumer, if you are using debt to buy things, as most people do when buying very expensive things like houses, cars, or college educations, you will be subject to a credit check by the lender. The credit check is meant to determine your credit worthiness. This is a fancy way of saying that the lender is determining how much risk they are taking by lending you money. The lower your credit score, the higher the risk to the lender, and the higher your interest rate will be (if they lend you money at all). The rate of interest you pay compensates the lender for taking the risk of lending you money.

When it comes to borrowing money, secured debt – debt that is backed by a real asset like a house or a car – is safer for the lender than unsecured debt, which has no backing other than the borrowers promise to pay. If the borrower can’t pay off the debt, the lender can seize the asset and sell it to make some of their money back. This means secured debt like mortgages, car loans, and securities-backed lines of credit, will have lower interest than unsecured debt like credit cards.

What does it actually mean, then, when the Federal Reserve is raising interest rates? Let’s think about this:

The stated reason for raising rates is to combat inflation, which is the phenomenon of the cost of goods rising due to too much money trying to buy too little stuff. But that’s what rising rates do, not what they are.

If the costs of stuff is rising, borrowers will need to spend more money, meaning individual and business cash reserves will potentially deplete faster than they can be replenished. This may mean that the borrowing entity may struggle to repay a debt obligation. Lending institutions may need to charge a higher rate of interest to be compensated for the risk of lending money in such an economic environment.

The downstream impact of the increased risk – and therefore the increased cost – of debt, is that it will require individuals and businesses to rely less on debt to finance expenses. This means banks will be issuing fewer loans, which will reduce the amount of money in circulation. We are seeing this now in the housing market and in the somewhat slowing rate of growth of new jobs. This is why rising rates can lead to recessions.

Also, the higher interest rates make short term Treasuries, which are ultra-safe as described above, look more appealing as interest-earning instruments. As people buy Treasuries, their money stops circulating the economy. Removing money from the economy by slowing down new issues of debt and enticing investors to buy Treasuries helps control the demand side of the supply/demand equation.

As money stops circulating, demand for new stuff slows. Prices fall as producers try to entice customers to buy stuff through lowering prices.

The end result, then, of rising interest rates, is to slow down inflation. Falling prices mean things like living expenses or business overhead will be less expensive, which will free up funds for people and businesses to buy goods and services again. Enough money buying enough things means people can make debt payments. This makes the prospect of lending money less risky, which will allows interest rates to fall. So…

Two young investors are walking to work.
They pass a retiree on her way to her morning yoga class.
“How are your interest rates looking today ladies?” asks the retiree.
“Sure, fine, hi” say the young investors, trying to be polite.
Once a safe distance away, one turns to the other and asks:
“What the heck is interest?”

Hopefully now you know how to answer.

Interest-earning instruments are integral to a risk-managed wealth protection strategy. If you have questions about this part of your portfolio and want some guidance, that’s what we’re here for.