Interest: what you are paid for lending

What a lender actually owns

A lender owns a claim: a promise to pay stated amounts on stated dates, and to return the principal at the end. You do not own the borrower, its growth, or any part of its success. If the company you lent to triples in value, your coupon is unchanged.

What varies between claims is where you stand if things go wrong. Secured lenders have specific collateral. Senior unsecured lenders rank ahead of subordinated ones. Every one of them ranks ahead of the owners. Seniority costs nothing while the borrower is paying and is the entire story once it is not.

That gives lending an asymmetric shape. The upside is defined the day you buy — hold to maturity and you receive the yield you agreed to. The downside is not defined and is not symmetric: an unpaid loan does not pay you less, it pays you a recovery, sometime later, after a process.

The insured deposit is the floor of the market

In the US, deposits at an FDIC-insured bank are protected up to the standard insurance limit per depositor, per insured bank, for each ownership category; credit unions have the same arrangement through the NCUA. If the institution fails, insured depositors are made whole by a federal agency, usually within days.

It is worth being precise about what that does not cover. Insurance applies to deposits — checking, savings, money-market deposit accounts and CDs. It does not apply to investment products bought through the same bank: mutual funds, money-market funds, annuities, stocks and bonds are not insured deposits, whatever the branch signage suggests. It does not protect balances above the limit, it does not stop the bank cutting the rate tomorrow, and it does not defend the purchasing power of the money.

Because the insured deposit is the safest place to put cash, it sets the reference point for everything else in this lesson. Any other borrower has to offer more than the deposit rate to get your money, and the difference is a price for something specific.

Even inside insured deposits there is a trade. A savings rate can change any day, at the bank's discretion. A CD fixes the rate for a term, which is why it usually starts higher — you have given up the ability to move.

Credit risk: the borrower may not pay

US Treasury securities are backed by the full faith and credit of the federal government and are treated as free of credit risk in the ordinary sense. Everything else — a bank, a corporation, a municipality, a private borrower — pays partly for its own ability to keep paying.

Credit risk has two parts that are easy to conflate: how likely default is, and how much you recover if it happens. A secured loan to a shaky borrower and an unsecured loan to a solid one can price similarly for very different reasons. Ratings are one agency's opinion on the first part; they are not a guarantee and they change after the facts do.

Diversification changes the shape of credit loss without removing it. Credit losses cluster: borrowers tend to struggle at the same time, for the same reasons, which is usually when the rest of your income is also under pressure. A portfolio of many loans converts an occasional total loss into a regular small one, which is a different experience but not a free one.

Term: you are paid for time

Lending for longer normally pays more, because more can go wrong and because your money is committed while it happens. That is the usual shape of the yield curve, but it is not a law: the curve flattens and sometimes inverts, and short lending can pay more than long lending for extended periods.

Once you own a fixed rate, that rate becomes a price. If new loans of the same kind start paying more, yours is worth less to a buyer, and the longer it has left to run the more its price moves. Held to maturity, those swings never change the cash you contracted for — but they are real if you need to sell, and the opportunity cost of being locked in is real either way.

Short terms simply swap one risk for another. Money that comes back quickly has to be lent again, at rates nobody knows yet. Reinvestment risk is the quiet twin of interest-rate risk, and a ladder of maturities is the standard structural response to owning both.

Liquidity: the price of not being able to leave

Treasuries trade in one of the deepest markets in the world; a private note signed with a local builder may have no market at all. Between those two sit corporate bonds, municipal bonds, bond funds, interval funds and non-traded vehicles, each with its own answer to 'what happens if I want out on Tuesday'.

Certificates of deposit make the distinction visible. A bank CD can normally be broken early for a penalty defined in the account agreement, so the cost of leaving is known in advance. A brokered CD is instead sold on the secondary market at whatever price prevails that day, which can be above or below what you paid.

Private lending vehicles often offer only periodic, limited repurchases, and those windows can be capped or suspended precisely when many holders want out at once. The extra yield on offer is genuine compensation for that restriction. It is also, exactly, the description of what you gave up.

Taxes decide what you keep

Interest is generally taxed as ordinary income at your marginal rate, reported on Form 1099-INT, with separate rules for instruments bought at a discount. That makes the headline rate on a taxable bond and the rate you actually keep two different numbers, and the gap is larger the higher your bracket.

Two exceptions matter structurally. Interest on US Treasury securities is exempt from state and local income tax, which is worth more in a high-tax state. Interest on most municipal bonds is exempt from federal income tax, and often from state tax for residents of the issuing state, though certain private-activity bonds interact with the alternative minimum tax.

Comparing a muni yield with a corporate yield without adjusting for that is a category error, and it is the single most common one in this mechanism. The tax-equivalent yield calculator on this site does the conversion; the arithmetic is simple and the result frequently reverses the ranking.

A higher rate is a description of what you accepted

Any lending rate can be read as a stack: the reference rate for that term, plus payment for credit risk, plus payment for illiquidity, plus payment for complexity, minus any tax advantage. If a rate is much higher than the reference, one of those components is doing the work, and finding out which is the whole of the research.

Structure can also be doing it. A callable bond pays a little more because the issuer can repay early — which they will tend to do when rates fall and you would least like the money back. A floating rate pays whatever the reference does, which removes price risk and adds income uncertainty.

None of this argues against higher rates; it describes what they are. This site shows what each part of the lending market currently pays and what sits behind it, and leaves the decision where it belongs.