The term “cost of money” refers to the interest that investors require for investing in risky assets because they have a choice of putting their money in risk-free investments, such as government bonds or a guaranteed time deposit. The cost of money is a very important aspect of finance because it affects the pricing of a great number of assets and investments. It dictates the rates at which businesses can borrow to finance their activities, and it determines mortgage rates, student loan rates, credit card rates and many other forms of financing. The cost of money rate, or interest rate, is influenced by central banks’ short term rates and governments’ bond rates, because they are used by everyone else as benchmarks when they lend, invest or borrow money.
For taking on additional levels of risk, investors will demand higher returns, so the price of stocks and bonds issued by corporations, for example, will be affected. Investors rationalize that bonds issued by stable governments, for example, are guaranteed to pay a fixed rate of interest, whereas corporations could go bankrupt because of numerous factors. For this reason, corporations will need to pay a higher rate of interest to investors to compensate for the extra risk, which will also have an effect on their bottom lines. Thus, the cost of money rate is set to reflect the risk and return relationship, which is that for low-risk investments, people will usually accept low returns, and for high risks, they normally will expect high returns.
Furthermore, when people price securities, such as stocks and bonds, they will use the interest on government bonds as a reference benchmark, and a risk premium will be added on, which is the return added on the risk-free rate. For example, if a 10-year government bond had a 5 percent fixed rate and a 10-year corporate bond had a 13 percent rate, then the risk premium would be 8 percent. Moreover, the benchmark government bond and the corporate bond will usually have the same length to maturity, and the higher the risk premium, the riskier the bond is. The cost of money is also tied to the fact that the value of a given amount of money today will decline in the future if no sufficient interest is earned. In other words, using an example, $1 US Dollar (USD) today is worth more than $1 USD in the future if there is no interest accrued on the $1 USD.
In the modern economy, most people play all of the roles of lenders, investors and borrowers and are affected in one way or another by the cost of money. For example, when a person deposits money in a bank, the bank might pay him or her a regular interest, and at the same time, the bank uses the deposited amount to provide credit to other individuals and institutions for their own purposes. A portion of the interest received from the different types of credits provided by the bank will go toward the interest payment to the depositor. Also, the same depositor might have a mortgage loan and/or a credit card from the same bank.