How Does Interest Rate Differential Affect Foreign Currency
An important consideration to make before investing in foreign currency is the interest rate differential (IRD). IRD is the difference in interest rates of two assets or the change in interest rates between two countries’ currencies.
Foreign exchange traders use IRD to predict the exchange rates of foreign currencies. If a particular currency’s value rises compared to another currency, it will attract more investors. An increase in the value of the currency makes it stronger.
Understanding Interest Rate Differential
Interest rate differential is mainly used in the foreign currency exchange market to determine the pricing of the currencies. However, the calculations are also used in fixed income calculations and mortgages.
People involved in the Carry Trade also often use IRD. Carry trade is a trading strategy where traders borrow cash at a low-interest rate and invest it in an asset that will gain a high return.
For example, when comparing a currency with a 3 percent interest rate and another with a 1 percent interest rate, the IRD is 2 percent. An investor who buys the currency with the higher interest rate against the lower one will earn on the difference with daily interest payments.
Reasons borrowers Pay Interest Rates
An interest rate is the added amount financial institutions charge on loans. The extra cash caters to the service and the risk of lending money. Although it is an added expense to the borrower, it keeps the economy moving and motivates people to borrow.
Besides, due to the difference in interest rates, borrowers consider the rates before applying for loans. This is because interest rates keep changing, and they are also different depending on the loan types.
The two main forces behind interest rates are lenders and borrowers. When a financial institution like the bank lends you money, they are risking because you could default on the loan. So the banks charge interest on the borrowed money to compensate for the risk.
In addition to the risk of default, many changes are happening to the economy. As inflation increases, the currency is slowly losing value. It means that the price of items will be higher in some years to come.
Therefore, an item worth $100 could cost about $150 in five years. Therefore, banks use interest rates to cover the rise in inflation. Without interest rates, they would be getting less money than they gave.
The other reason borrowers pay interest rates is that they get access to money they would have waited years to use. The loan is a favor the bank extends to the borrower, and they charge interest rates as compensation.
Factors Determining Interest Rates
Interest rates are different in countries because of the difference in their economic states. For example, countries have various demand and supply levels, inflation, and government policies. These factors affect interest rates in the following ways:
1. Supply and demand
Supply and demand play a huge role in a country’s interest rates. When there is a high demand for money, people will borrow more. Financial institutions increase interest rates to discourage borrowing.
When the demand for money is low, banks reduce interest rates. Reducing the rates means that borrowers will pay little cash on top of the borrowed amount, encouraging them to take loans.
More credit supply reduces the interest rates—the supply of credit increases when more banks lend people money. So, like commodities, an increase in supply leads to a decrease in prices, similar to interest rates.
Another huge determinant of interest rates is inflation. Inflation is an increase in the prices of items due to a fall in purchasing power of a currency. Therefore, a high inflation rate leads to a rise in interest rates.
When a bank lends you money with a payment period of five years, the cash will have a lower value than it does now. Therefore, to compensate for the lost value within that period, the borrowers pay a higher amount than they borrowed.
3. Government policy
A country’s government creates monetary policies that can dictate loan interest rates. For example, it could buy or sell securities to increase or reduce the money in supply.
For example, when the government buys securities, there is a lot of money flow in banks, meaning they have enough to lend. Hence, the banks decrease the interest rates.
On the contrary, money in the financial institution gets drained when the government sells securities. This leaves the banks with less money to lend out, increasing their interest rates.
4. Type of loan
The interest rate of the different types of loans depends on tax considerations, risks of default, and time. If the loan is at a high risk of default, the lender charges a high-interest rate.
However, the interest rates are lower if the borrower presents collateral that the bank can use to raise the amount in case of default. Collateral can be a car, land, or a house.
A long-term loan has higher interest rates because the borrower is more likely to default on the payment. High-interest rates apply in these loan types also because of cases of inflation.
Canadian Interest Rate Differential
Interest rate differential in Canada mainly applies if you pay off your mortgage before it matures. The interest rate differential is calculated based on the amount you are pre-paying and the difference in interest rates.
The difference in rates comes by comparing the actual rates of the mortgage with the rates you could be paying if the lender loaned you the funds for the remaining mortgage today.
Lenders use IRD if the buyer has a higher interest rate on the mortgage than the current interest rate. IRD also applies if five years have not ended after the homebuyer signed the contract.
The lenders IRD to compensate for the lost payments they would have gotten if they lent a different person the loan. It mainly affects homeowners who want to pay off their mortgage early.
When taking a mortgage, sometimes the lender will tell you they are offering you the loan at a discounted rate. However, most lenders will not consider the discount rate they used when calculating the interest rate differential.
While paying off a mortgage early can seem advantageous to the lender, it results in less income received than if you waited to pay the loan within the agreed period. If the interest rates are lower as the years pass, the next person the bank lends the money to will pay less.
To save themselves from the lower gains of their loans, lending firms apply penalizing rates like IRD for people who want to pay off their loans early.
Forex Traders Should Be Cautious
When there is a massive difference in IRD, forex traders take it as an opportunity to invest. The truth is, this difference could signal trouble. These rates tempt most traders to sell the market currencies, which is inadvisable.
If you are considering paying off your loan or mortgage earlier than the agreed time with the bank, you should first learn about interest rate differential. Most lenders will use this to calculate the amount to repay your mortgage, which could be more than paying the loan at the agreed time.