Interest Rate

Part of the cost charged by a lender for the using their funds to finance a deal.

What Is an Interest Rate?

An interest rate is a specific percentage or amount that the lender charges the borrower, either monthly or annually, on the principal amount. When a bank or any financial institution lends money to a borrower for a specific period of time, they impose a certain amount that the borrower must pay back in addition to the monthly payments on the principal amount. This amount is known as interest. 

It is levied so that the lender can earn a profit on helping a borrower with money. It also creates an urgency and discipline for the borrower to pay back the principal amount within the given time frame or else the amount to be paid on interest will keep on increasing. 

What Is the Importance of Interest Rate?

Interest rate is not only a significant factor for borrowers and lenders but it affects the economy as well. In almost every aspect of investment, interest rates are important. For example, if your savings account offered 12% interest instead of 8% you would want to keep more money in the account. Additionally, if you get a higher interest rate in one bank’s savings account, you would want to stick to the bank offering higher interest. 

In the economy, interest rates serve as a metric to measure the coordination between savers and borrowers. As savers are paid interest on their savings, this encourages them to reduce their consumption and save more as the higher the savings, the higher the returns as interest. On the other hand, borrowers are charged an interest as they need to consume in the present. 

So, when the amount of savers is higher than the amount of borrowers, the interest rates reduce. However, when more people borrow that the savings can manage, the interest rate goes up. Additionally, banks and every other sector is simultaneously affected by this change in the economy. 

What Are the Different Types of Interest Rate?

There is more than one type of interest rate because there are different types of loans available to borrowers. From short-term loans to long-term loans, personal loans to student loans, and mortgages, people can get help with money easily. Here are the different types of interest rates:

1. Fixed interest: In this, the interest rate is fixed for the duration of the loan and both the borrower and the lender can calculate the cash flow. 
2. Variable interest: Here, the interest rate is not fixed, it fluctuates. The interest rate will vary throughout the duration of the loan as the lender reevaluates the rate after a fixed period and as per the market conditions.
3. Annual percentage rate: The APR determines the total interest that the borrower pays annually on the loan. This is most commonly used by credit card companies to set interest rates when customers carry a balance on their credit card. 
4. Prime rate: The prime rate is used by banks as a base to determine the interest rate for most creditworthy corporate customers. It is based on the federal funds rate. 
5. Discount rate: This is an interest rate that the U.S. Federal Reserve uses to lend money to banks and other financial institutions for short-term loans.
6. Simple interest: A simple interest rate is used by banks to calculate the interest rate for borrowers, usually on an annual basis. This is fixed rate and does not involve compounded interest.
7. Compound interest: A compound interest is calculated for interest that is charged on interest.  

What Is the Formula for Interest Rate?

As there are different types of loans (like stated above), there is no fixed formula for calculating the interest rate. However, borrowers can calculate the interest based on the type and duration of their loan. Additionally, people can also calculate the interest they will receive in their savings account. 

The formula usually involves calculating the given percentage of interest on the principal amount for the given duration. For example, the formula to calculate simple interest on a loan is Principal ( P ) x Rate of interest ( R ) x Number of months/year ( N ).  

Let’s understand this with an example. Suppose a borrower takes a loan of $5000 for 2 years and the lender charges an annual interest of 5%. Here, the interest would be:

Interest = 5000 x 5% x 2 OR 5000 x 0.05 x 2 OR = 500 

Hence, the interest to be paid by the borrower in 2 years would be $500.

Conclusion

Interest rate is an important factor for borrowers, lenders and investors as it determines the cash flow monthly or annually. Before taking a loan, a borrower must check all the terms of the loan and compare the interest rate to get the lowest interest rate possible. On the other hand, an investor must consider all the options and choose the one that guarantees maximum return on investment. 

‍