Can someone please explain to me thoroughly the purpose of interest rates in banks please?

Expert Answers
pohnpei397 eNotes educator| Certified Educator

Traditionally, there have been two purposes for interest rates with regard to banks.  Today, only one of them is really relevant. 

The purpose for interest rates that is now obsolete is to attract deposits.  Banks want people to deposit money with them.  The reason for this is that the banks take the money deposited with them and loan it out and use it for other investments.  This is one of the main ways in which banks make money.  Therefore, banks pay interest on money that is deposited with them.  However, interest rates are so low today that they are not a serious way to attract deposits.

The purpose for interest rates that still matters is to make money for the bank.  When the bank loans your money out, it charges interest.  What that means is that the person or company that borrows from the bank has to pay back all of the principal (the money that it borrowed) but it also has to pay interest.  The interest that the borrower pays is a percentage of the principal.  To take a very simplified example, if a bank loans you $100 for a year at 5% interest, you must pay back $105 ($100 principal plus 5% of that $100 in interest).  By charging interest, the bank makes money on its investments.

Parker101 | Student

Thank you!