What makes an interest rate high? What makes one low?

In an academic world, interest rates are the cost of inflation plus the price of risk, plus a little extra profit margin. In the practical world, the same is mostly true. The only real difference is that lenders and borrowers (bankers) don’t have to worry about the cost of inflation, but instead their own cost of capital.

How else could banks convince us to loan them money at .5% when the CPI is running at 2-3% per year? They have us exactly where they want us! Banks can both borrow and lend at a rate under the rate of annual inflation. Cool, huh?

### My High Interest Point of View

I think an interest rate becomes “high” when it crosses the point at which it is greater than 2x the long bond yield. So if 30-year US Treasuries yield 3.5%, a high interest rate is somewhere in the neighborhood of 7%.

A super-high interest rate would be 3x the risk-free rate, or 10.5% when the 30-Year US Treasury yields 3.5%. You really frequently encounter super-high interest rates only in financing models for convenience and risk. For example, a credit card company charges 17% or more to cover the cost of billing and small dollar accounts. A payday lender like Jaguar payday loans charges 1700%+, mostly to cover risk and the cost of doing business with thousands of people borrowing small sums of money.

These numbers aren’t exactly picked at random. Ben Graham always wanted 2x the risk-free yield on his investments. I like to invest in companies that provide free cash flow yield twice that of the US Treasury yield.

### Interest Rates are Fairly Efficient

The bond market may be one of the most illiquid markets for its size, but it does price very well the cost of risk in any particular investment. It also accurately prices the relationship between the riskiness of “risk-free” government bonds and riskier companies and individuals.

These rates also flow into the stock market, and all other financial markets. When rates drop, housing prices (usually) go up. When rates drop, dividend paying stocks become attractive. When rates rise, people retire and move from equity exposure to fixed-income exposure. So all this does, on some level, get priced in.

Which is exactly why I like to use a multiple of the US Treasury rate. Simple, clean, and easy to use – I’ll slap a “high-interest” label on anything that yields/costs more than 2x the yield on the long bond.