What are the components of an interest rate? Why is it important for accountants to understand these components?
The interest rate generally has three components:
(a) Pure rate of interest—This would be the amount a lender would charge if there were no possibilities of default and no expectation of inflation.
(b) The expected inflation rate of interest—Lenders recognize that in an inflationary economy, they are being paid back with less valuable (future) dollars. As a result, they increase their interest rate to compensate for this loss in purchasing power. When inflationary expectations are high, interest rates are high.
(c) Credit risk rate of interest—The U.S. government has little or no credit risk (i.e., risk of nonpayment) when it issues bonds. A business enterprise, however, depending upon its financial stability, profitability, etc. can have a low or high credit risk.
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