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What is interest rate?

In Banking, Finance on July 2, 2012 at 3:56 pm

Interest rate is the amount payable to creditor by the debtor for the use of money for the certain period or the money earned by an investor on a debt instrument for specific time. Here creditor is the person who gives the loan or makes investment in a debt instrument while debtor is a person who takes the loan or an institution who float a debt instrument like debentures, debt securities etc. Interest rate is very widely used terms and it is not only charged only for loans but also charged for mortgages, credit cards and unpaid bills.

Interest rate is dependent upon the amount of loan, duration, financial position on debtor, type of loan (e.g.: secured/unsecured), economic condition of the country and the economic policy of the country. It is very simple to understand such as a person takes a home loan for 8% interest rate or 18% interest rate, in first condition he will be able to repay the loan very early than the second condition assuming the EMI (every monthly instalment) in both the conditions are the same.

Interest rate can be expressed in monthly, quarterly, half-yearly and annual rate which is sometimes described as mode of payment for annual interest payments. For example: 18% annual interest rate can be paid through different mode of payment – monthly 1.5%, quarterly 4.5%, half-yearly 9% and annually 18% at one time.

 

Basically, interest is of 2 types – simple interest and compound interest. Simple Interest is paid on amount of money taken as loan or mortgage and can be calculated by using the formula:

Simple Interest

I = P * r * t

Here:

‘I’ stands for Interest

‘P’ stands for principal

‘r’ stands for rate and

‘t’ stands for Time.

For example, if I invest $1000 (the Principal) at a 5% annual rate for 1 year the simple interest calculation

I=P * r * t

$50 = $1000 x 5 % x 1 yr

Compound Interest

Compound interest is interest that is paid on both the principal and on any interest from past years. It’s often used when someone reinvest any interest they gained back into the original investment. For example, if I got 15% interest on my $1000 investment, the first year and I reinvested the money back into the original investment, then in the second year, I would get 15% interest on $1000 and the $150 I reinvested. Over time, compound interest will make much more money than simple interest. The formula used to calculate compound interest is:

M = P( 1 + i )n

M is the final amount including the principal.

P is the principal amount.

i is the rate of interest per year.

n is the number of years invested.

Applying the Formula

Let’s say that I have $1000.00 to invest for 3 years at rate of 5% compound interest.

M = 1000 (1 + 0.05)3 = $1157.62.

You can see that my $1000.00 is worth $1157.62.

Notes: With the simple interest, my worth would have been just 1000*.05*3 = $1150, therefore I gained $7.62 more due to compound interest.

These topics will be covered in other blogs:

  • How interest rates are decided in different countries?
  • Why interest rates are different in different banks, different types of loans?
  • Why Credit cards charge very heavy interest rates like 35% or 40%?
  • How Interest rates are linked with country economy – what will happen if it will go too up or too low?
  • What is NPA?
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