Lesson 06 · 4 min · 6 things to do
The price of time
Work out why interest rates move the price of everything else.
Would you rather be promised £1,000 today or £1,000 in ten years?
- Yes.That preference has a price, and that price is the interest rate. Everything else in this lesson follows from money now being worth more than the same money later.
- Not quite.The same number, and not the same thing. Ten years of use, or of prices rising, sit between them.
- Not quite.Inflation is one part. Even with prices perfectly flat, having it now leaves you options you would otherwise not have.
An interest rate is the price of time. It says what a pound next year is worth in pounds today — and everything with a future payment is priced with it.
An asset pays £100 a year forever. Slide the interest rate and watch what it is worth today.
1%2%5%10%Worth today at this rate£10,000Worth today at 1%, for comparison£10,0001%Worth about £10,000. When money is nearly free, distant payments count for almost their full value.
Worth today at this rate£5,000Worth today at 1%, for comparison£10,0002%£5,000. The rate doubled and the value halved.
Worth today at this rate£2,000Worth today at 1%, for comparison£10,0005%£2,000. A fifth of what it was worth at 1%.
Worth today at this rate£1,000Worth today at 1%, for comparison£10,00010%£1,000. The same income stream, a tenth of the price.
The £100 a year never changed. Why did the value move so violently?
- Yes.It is the closest thing in finance to a law of gravity: when the rate moves, everything with a future payment reprices, whether or not anything about the asset changed.
- Not quite.Mood follows. The arithmetic happens whether anyone feels anything.
- Not quite.Inflation is one reason rates move. The repricing happens for the rate itself, whatever caused it.
Move the control to see what changes.
When interest rates rise sharply, which of these fall hardest?
A company whose profits are expected in fifteen years.
A 30-year bond paying a fixed amount.
A shop making steady cash this month.
A start-up promising to earn money eventually.
A short-term deposit maturing in three months.
Yes.The further away the money is, the more the rate has to work on it. Rate rises fall hardest on things whose whole value is in the future — which is why the same rise looks like a technology story and not a supermarket story.An asset pays £100 a year forever. At an interest rate of 4%, what is it worth today, in pounds?
£Yes.£100 ÷ 0.04. Dividing the annual payment by the rate is the whole calculation for a payment that never ends — and it shows why halving the rate doubles the price.Rates rise and house prices fall, even though the same number of people want houses. Why?
- Yes.Most house buyers are really buying a monthly payment. When the rate rises the payment buys less principal, so the price a buyer can offer falls without anybody wanting a house less.
- Not quite.The desire is held constant in the question, and the effect appears anyway.
- Not quite.The mechanism is in the buyer's affordability, and it is arithmetic rather than mood.
Why is a change in interest rates described as moving "the price of everything"?
- Yes.Shares, bonds, houses, farmland, a business — all of them are streams of future payments. One number reprices them all at once, which is why rate decisions dominate financial news.
- Not quite.They set one rate and the rest is other people's arithmetic. Control is much weaker than that phrase suggests.
- Not quite.Credit amplifies it. The repricing happens even for a buyer who never borrows a penny.
Lesson complete
An interest rate is the price of time, and it reprices everything with a future.
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