What Is An Interest Rate?
The basic interest rate definition describes the cost of borrowing money. The rate is a percentage charged by a lender for lending an amount to a borrower for a specified period of time. Moreover, it’s a rate of return for lenders, reflecting the time value of money and risk of lending. The rate is most commonly quoted as an annual percentage rate (APR).
The more trustworthy a borrower seems, the lower the interest percentage will be. Lenders assess risk by accessing credit reports. Therefore, maintaining a good score is vital to securing competitive rates.
When Interest Rates Are Used
Interest rates are applied to almost all lending and borrowing activities. Personal and business borrowing can be used to fund a number of different activities. Subsequently, lenders are repaid either with one single payment or more commonly in installments.
Creditors expect compensation for lending out their capital. Accordingly, the amount repaid will be greater than the original sum borrowed. The difference between the amount borrowed and the amount repaid is the interest in the transaction.
For instance, a person borrows $250,00 from a bank as a mortgage, and the loan comes with 20% interest. They’d be required to pay back $250,000 + (20% x $250,000) = $250,000 + $50,000 = $300,000.
Simple Interest Rate Formula
The above example used a simple interest rate formula: principal x rate x time
The borrower paid $50,000 in interest, assuming there was a single year repayment period. If the loan is for a longer period, the charges rise significantly. For a 10-year repayment, the charges would be: $250,000 x 20% x 10 = $500,000.
The 20% APR equates to an annual charge of $50,000. After 10 years, the lender will make $500,000 in interest charges. This demonstrates how banks can make huge profits. The borrower would’ve also paid back the $250,000 principal amount, so their total repayment equals $750,000.
Compound Interest Method
Some lenders utilize compound interest, which is interest on interest. This additional interest is applied to the principal and to the interest accumulated earlier in the loan period.
If the interest paid is annual, after 12 months, the borrower owes the principal amount plus interest for that year. After 24 months, the borrower owes the principal amount plus interest on the first year plus interest on the first year’s interest. This accrues higher interest percentage charges compared to simple interest. The longer the loan term, the greater the disparity in charges.
Let’s look into this further using the initial example from earlier with an annual interest of 20%.
After year one, the interest on the $250,000 principal is $50,000 with both methods. However, with compound interest, interest is calculated on the principal amount and the first-year interest. Thus, interest for the second year is $60,000, then $72,000 for the following year (20% of $360,000). After five years, this has risen to $103,680.
The compound interest formula is as follows:
p x [1 + interest rate)n – 1]
p = the principal amount
n = the number of compound interest periods.
Those with savings accounts can benefit from compound interest. Compounded interest acts as compensation for account holders since they’ve permitted the bank to use the deposited funds.
For instance, a business deposits $250,000 and a bank uses $150,000 for a mortgage loan. To compensate, the bank annually pays 6% interest to the account. Additionally, the bank takes 15% annually from the borrower, which totals the interest at 9%. The accumulation of compound interest charges over time can help build capital for savers even when rates are low.
APY And APR
Personal loans are usually advertised by quoting the annual percentage rate (APR). This is the charge lenders impose on borrowers. It’s their annual rate of return on the loan. Credit cards are listed with APRs and don’t take compound interest percentages into consideration. It’ll include other charges associated with a line of credit. Therefore, it’s usually higher than an interest rate.
The annual percentage yield or APY is a rate that a credit union or bank will earn from a savings account or a certificate of deposit (CD). Unlike the APR, this rate takes compound interest into consideration.
Cost Of Debt
Lenders are influenced by their nation’s rate, which is set by central banks. Additionally, inflation and the strength of the economy can affect the APR.
A high lending and borrowing rate makes debt more expensive. This encourages less borrowing, which reduces consumer demand. It also encourages saving, less investment in stocks, and economic contraction. Moreover, when rates are low, economies can be stimulated by competitive rates on loans.
Bottom Line
The interest rate meaning is the return that a lender seeks for providing funds for a specified period of time. These percentages act as a guide to borrowers on the cost of credit. In the past, you may have found yourself googling things like, “interest rate for dummies.” However, after reviewing the above examples and definitions, you should now have a better idea as to how these rates affect your finances.
