Interest Rate Risk Premiums And Your Nest Egg

Conventional wisdom states that great rewards come with big risks

. This also holds true in the realm of investment opportunities, although high risks and bigger premiums may be more applicable. When you invest your money, or borrow it by way of a loan, it's possible that the principal amount you invest or borrow won't return to where it should go.

The high rate of return or profit associated with comparatively riskier investments is what's known as a risk premium. In relation to this, the costly interest rate you pay a lender who undertakes much more risk than usual is known as a debt risk premium. In a nutshell, the additional return rate a creditor or investor charges, aside from the principal amount or original yield, comes from the greater risks he or she becomes involved with in this kind of transaction.

If you're an investor who has a low credit score, you're required to pay larger amounts for your mortgage, or have higher interest rates when it comes to credit card transactions - this is one example wherein a debt risk premium is in play. Because there's more risk involved, compared to transacting with an investor or lender with good credit, the risk premium can work against you. In some cases, this may also be favorable if your investment pays out, or you don't default on your loan payments.

The interest-rate risk premium can be a factor in the case of the higher gains some bonds yield. Usually, financially stable businesses pay out yields for bonds at lower rates than businesses that are at risk, such as those that don't have good track records, or are just starting out. The lower rates are there to attract bond investors who may be willing to buy into riskier investments, as there's a good chance that the investor won't get his or her initial investment back. The increased risk is alleviated by the rewards of higher investment returns - a basic principle governing most other investment venues and tools.

When choosing an investment that's riskier than normal, consider your actions possible repercussions on your finances, both positive and negative. Study up on the lender or investment's performance, and consult with an investment advisor to check if your financial goals and situation can handle possible losses.

by: Carina Smith

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