What are Interest Rates?
An interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. The asset borrowed can be in the form of cash, large assets such as vehicles or buildings, or just consumer goods. In the case of larger assets, the interest rate is commonly referred to as the “lease rate.”
The interest rate for a loan is expressed as a certain percentage over a year (e.g. 10 per cent per annum, or 6 per cent per annum). The higher the loan interest rate, the more money you have to repay. Also, the lender can choose to express the loan interest rate on a monthly basis, especially for short-term loans.
Basically, the rule is that the longer the loan tenor (time to repay), the higher the loan interest rate. The shorter the loan tenor, the lesser the interest rate.
Interest rates are directly proportional to the amount of risk associated with the borrower. Interest is charged as compensation for the loss caused to the asset due to use. In the case of lending money, the lender could have invested the money in some other venture instead of giving it as a loan. In the case of lending assets, the lender could’ve generated income by making use of the asset himself. Thus, in return for these lost opportunities, interest rates are applied as compensation.
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The annual interest rate refers to the rate that is applied over a period of one year. Interest rates can be applied over different periods, such as monthly, quarterly, or bi-annually. However, in most cases, interest rates are annualized.
What are the types of Interest rates?
There are many types of Interest Rates that borrowers and lenders encounter. According to nature and purpose, the interest rates vary from one another. However, we will discuss the seven top types of Interest Rates and they are as follows:
List of Top 7 Types of Interest
- Fixed Interest Rate
- Variable Interest Rate
- Annual Percentage Rate
- Prime Interest Rate
- Discounted Interest Rate
- Simple Interest Rate
- Compound Interest Rate
1. Fixed Interest
A fixed interest rate is the most common type of interest rate, which is generally charged to the borrower of the loan by lenders. It is exactly as it appears- a specific, fixed interest tied to a loan or a line of credit that must be repaid, along with the principal. A fixed rate is the most common form of interest for consumers, as they are easy to calculate, easy to understand, and stable – both the borrower and the lender know exactly what interest rate obligations are tied to a loan or credit account.
As the name suggests, the rate of interest is fixed throughout the repayment period of the loan and is usually decided on an agreement basis between the lender and the borrower at the time of granting the loan. This is much easier, and calculations are not at all complex. This is much easier, and calculations are not at all complex.
Explanation: For instance, Mr A takes a loan of $10,000 from a bank to a borrower. Given a fixed interest rate of 5%, the actual cost of the loan, with principal and interest combined, is $10,500. This is the amount that must be paid back by the borrower.
Pros and Cons:
- Clarity: It gives a clear understanding both to the lender and the borrower what is the exact amount of interest rate obligation, is associated with the loan.
- Fixed interest is a type of interest rate where the rate does not fluctuate with time or during the period of the loan. This helps in the accurate estimation of future payments to be made by the borrower.
- One drawback of a fixed interest rate is that it can be higher than variable interest rates, it eventually avoids the risk that a loan or mortgage can get costly for a period of time.
2. Variable Interest
A variable interest rate is just the opposite of a fixed interest rate. Here the interest rate fluctuates with time.
Interest rates can fluctuate, too, and that’s exactly what can happen with variable interest rates. Variable interest is usually tied to the ongoing movement of base interest rates (like the so-called “prime interest rate” that lenders use to set their interest rates.) Borrowers can benefit if a loan is set up using variable rates, and the prime interest rate declines (usually in tougher economic times.)
That said, if base interest rates rise, then the variable rate loan borrower may be forced to pay more interest, as loan interest rates rise when they’re tied to the prime interest rate.
Banks do this to protect themselves from interest rates getting too out of whack, to the point where the borrower may be paying less than the market value for interest on a loan or credit.
Conversely, borrowers gain an advantage, too. If the prime rate goes down after they’re approved for credit or a loan, they won’t have to overpay for a loan with a variable rate that’s tied to the prime interest rate.
Explanation: Suppose a borrower, say Mrs D is given a home loan for a period of 15 years, and the loan amount sanctioned is $100000 at a 10% interest rate. The contract is set as for the first five years, the borrower will pay a fixed rate of 10 %, i.e., $10000 years, whereas, after the period of 5 years, the interest rate will be on a variable basis assigned to the prime interest rate or base rate. Now suppose after 5 years, the prime rate increases, which eventually increases the borrowing rate to 11 %. Thus now the borrower pays $11,000 yearly, whereas if the prime rate falls and the borrowing rate becomes 9%, the borrower in such a scenario saves money and only ends up paying $9,000 yearly.
Pros and Cons:
- In this case, the borrowing rate also goes down. This generally happens when the economy is passing through a crisis situation. On the other hand, if the base interest rate or the prime interest rate rises, the borrower is forced to pay a higher rate of interest in such scenarios. Banks will purposely do such to safeguard themselves from interest rates as low as that the borrower ends up giving payments, which are comparatively lesser than the market value of the interest for the loan or debt.
- Similarly, the borrower has an added advantage when the prime rate of interest falls after a loan is approved. The borrower does not have to overpay for the loan with the variable rate, which is assigned to the prime interest rate.
3. Annual Percentage Rate (APR)
The annual percentage rate is the amount of your total interest expressed annually on the total cost of the loan.
Annual Percentage Rate is very common in credit card companies and credit care mode of payment methodology. Here the annual rate of interest is calculated as the amount of the total sum of interest pending, which is expressed on the total cost of the loan. Credit card companies often use APR to set interest rates when consumers agree to carry a balance on their credit card accounts.
APR is calculated fairly simply – it’s the prime rate plus the margin the bank or lender charges the consumer. The result is the annual percentage rate.
Explanation:
Suppose we have a credit card with a 24% APR. It means for 12 months, we are charged at a rate of 2% per month. Now all months won’t have equal days; thus, APR is further divided by 365 days or 0.065%, which is called the DPR. Thus interest rate finally stands for DPR or the daily rate multiplied by the daily card balance, and then further, this result is multiplied by the number of days in the billing cycle.
Pros and Cons:
Credit card companies will apply this method when a customer carries forward their balance instead of repaying it fully. The calculation of the annual percentage rate is expressed as the prime interest rate, and along with this, the margin that the bank or lender charges are added upon.
4. The Prime Rate
The prime rate is the interest that banks often give favoured customers for loans, as it tends to be relatively lower than the usual interest rate offered to customers. The prime rate is tied to the U.S. federal funds rate, i.e., the rate banks turn to when borrowing and lending cash to each other.
The prime rate is the rate that is generally given by the banks to their favoured customers or to customers with a very good credit history. This rate is generally lower than the usual lending/borrowing rate.
Explanation:
A corporate has a regular loan history and very good repayment history too with the bank approaching the lender for a short-term loan, the bank can arrange for the same at a prime rate and offer it to its customer as a good gesture of relationship.
Pros and Cons:
- Not all customers will be able to opt for this loan.
5. The Discount Rate
This interest rate is not applicable to the common public. This rate is generally applicable for Federal Banks to lend money to other financial institutions on a short-term basis, which can be as short as a single day.
The discount rate is usually walled off from the general public – it’s the interest rate the Apex Banks (Central Bank for Nigeria, U.S. Federal Reserve for the U.S.A) lend money to financial institutions for short-term periods (even as short as one day or overnight.)
Banks lean on the discount rate to cover daily funding shortages, correct liquidity issues, or in a genuine crisis, to keep a bank from failing.
Explanation:
Suppose at times when the loans/lending becomes more than deposits in a single day; a particular bank may approach the Federal Bank to grant loans at a discounted rate to cover up their liquidity or lending position for the day.
6. Simple Interest
The term simple interest is a rate banks commonly use to calculate the interest rate they charge borrowers (compound interest is the other common form of interest rate calculation used by lenders.)
Simple interest (SI) refers to the percentage of interest charged or yielded on the principal sum for a specific period.
Like APR, the calculation for simple interest is basic in structure.
To determine simple interest: Principal x interest rate x n = interest
Explanation: Suppose a bank is charging 10% rate of interest on a loan for $1000 for three years, the simple interest calculation stands to be $1000 * 10% *3 = $300
7. Compound Interest
The compound Interest methodology is called interest on interest. The calculation is generally used by banks to calculate the bank rates. It is basically made on two key elements, which are the interest of the loan and the principal amount. Here banks will first apply the interest amount on the loan balance, and whatever balance is pending will use the same amount to calculate the subsequent year’s interest payment.
Banks often use compound interest to calculate bank rates. In essence, compound rates are calculated on the two key components of a loan – principal and interest.
With compound interest, the loan interest is calculated on an annual basis. Lenders include that interest amount to the loan balance, and use that amount in calculating the next year’s interest payments on a loan, or what accountants call “interest on the interest” of a loan or credit account balance.
Use this calculus to determine the compound interest going forward:
Here’s how you would calculate compound interest:
- Principal times interest equals interest for the first year of a loan.
- Principal plus interest earned equals the interest for the second year of a loan.
- Principal plus interest earned times interest equal interest for year three.
The key difference between simple interest and compound interest is time.
Let’s say you invested $10,000 at 4% interest in a bank money market account. After your first year, you’ll earn $400 based on the simple interest calculation model. At the end of the second year, you’ll also earn $400 on the investment, and so on and so on.
With compound interest, you’ll also earn the $400 you receive after the first year – the same as you would under the simple interest model. But after that, the rate of interest earned rises on a year-to-year basis.
Example: Let us take an example where we have made an investment in the bank for $1000 at 10% interest. First-year we will earn $100 and second-year the interest rate will be calculated not on $10,000 but on $10,000 + $100 = $10,100. Thus we will earn slightly more than what we would have earned under a simple interest format.
What factors determine interest rates?
- The amount of interest paid depends on the terms of the loan, worked out between the lender and the borrower.
- Interest represents the price you pay for taking out a loan – you still have to pay off the base principal of the loan, too.
- Interest on loans is usually pegged to current banking interest rates.
- Your interest rate on a credit card, auto loan or another form of interest can also depend largely on your credit score.
- In certain cases, like with credit cards, your interest rate can rise if you’re late on a payment, or don’t make a payment.
There are a number of factors that determine the interest rates offered by banks in return for your investment. These include; the chance of default by the borrower, the residual term, the payback currency, the respective country credit rating, the number of commercial banks in the country, and the national projections of savings vs. credit. The type of savings account chosen is also a determining factor.
Summary
Financial Services Industry works on various types of interest rates. These types of interest rates are useful for retail investors, institutional investors, banks, governments, financial institutions, corporates, and many other participants. All these interest rates have different characteristics and serve different purposes. They all are equally important.
So, now you know invariably all you need to know about Interest Rates, so you can make more sound financial decisions! Hurray.