What Is An Interest Rate And Everything You Need To Know About It
When coming to grips with personal finances, it is legitimate to ask the question: what is an interest rate?
In short, it is the amount lenders charge that is a percentage of the total borrowed amount. It can also sometimes be referred to as an annual percentage rate (APR), as the rates are calculated annually.
The borrowed assets could include direct cash, vehicles, buildings, or consumer goods.
How Interest Rates Work
Whenever you borrow something, an interest rate is basically calculated as the lease or rent charges you would pay for the asset borrowed. When the assets are large and valuable, like a building or vehicle, the interest rate could be essentially considered the lease rate.
Your interest rates could be lower if your case is considered as low risk by the lender. However, if the lenders consider your case risky in terms of repayment, you will be charged higher interest rates. The interest rates are applied to the principal amount, which refers to the total value of the loan.
How Are Interest Rates Levied On Loans
Interest rates apply to almost every borrowing transaction. People tend to borrow to pay for educational degrees, buy homes, purchase assets, or fund projects.
Businesses borrow to fund their projects and buy assets like buildings or land to expand their operations. The borrowed money then has to be repaid through periodic installments or as a lump sum amount on a decided date.
The money to be repaid will be more than what was borrowed. This ensures lenders are compensated for taking the risk of lending funds that could’ve been invested elsewhere for a return. The additional amount that the borrower pays above the borrowed amount is the interest.
Interest can be calculated in the following way:
If you take a loan of $400,000 from a bank at a 10% interest rate for one year, the amount you will have to repay would be:
$400,000 + (10% x $400,000) = $400,000 + $40,000 = $440,000.
Different Types Of Interest Rates
Simple interest rates and compound interest rates are two types of interest rates. Let us understand how they work.
Simple Interest Rates
The simple interest rate can be calculated in the following way:
Simple Interest= Principal x Interest Rate x Time
If we consider the above example, a 10% interest rate leads to an annual interest payment of $40,000. If the loan was taken for 15 years, the interest amount would be $40,000 x 15 = $600,000
Compound Interest Rates
If you opt for compound interest rates, you will end up paying even more interest. The interest is not only applied to the principal amount but also on the accumulated interest.
The interest amount increases exponentially if the loan duration is longer. The compound interest rate is calculated as follows.
Compound Interest = Principal x [(1 + Interest Rate)N – 1].
‘N’ here is the number of compounding periods.
If you initially borrow $300,000 at 15% for 20 years, the total owed amount after 20 years would be $4,909,961 if interest is compounded once annually. This is more than 16 times what you borrowed.
What Is APR and APY
The annual percentage rate (APR) is essentially the interest rate on consumer loans. The fixed number will be the rate at which you will repay the money to the lender.
The annual percentage yield (APY) is typically calculated by banks or credit unions to represent earned interest from certificates of deposit (CD) or savings accounts.
APY takes compounding interest rates into account. APR works exactly the opposite in this regard.
Factors That Affect Interest Rates
Several factors affect interest rates, like the current state of the economy. Every country’s central bank sets the base interest rate, which banks in turn use to calculate interest for borrowers.
Debt costs increase when interest rates rise. This may lead to less borrowing due to higher interest rates. When interest rates are higher, people usually save more as they receive better rates on savings accounts.
However, this scenario can directly impact stock markets and businesses, in turn affecting the overall economy.
The interest amount is the sum that you would additionally pay while repaying a loan. Most loan types make use of simple interest rates. In some cases, compound rates might also be used like for credit cards.
When you decide to borrow, make sure you carefully study all the aspects of the loan, including what is interest rate, loan duration, etc and how it will impact your finances. It will help you plan well and avoid any financial stress later.