Making a financial decision without a proper understanding of different types of interest rates can be a daunting thing to do. To make informed decisions, it is really important to educate yourself about different types of interest rates. In this article, we are going to develop an understanding of interest rates by discussing a comprehensive breakdown of their different types and enabling informed financial choices.
What is an Interest Rate?
Interest rate is the amount or fee a lender charges a borrower that is usually calculated in the percentage of the amount given as a loan. However, the interest rate on an amount is typically calculated annually it can be represented as the Annual Percentage Rate of the loan.
If you have a certificate of deposit or saving account, then the bank or credit union will have to pay a percentage of the funds you have deposited in that account. The annual interest that is earned by depositing funds in a savings account is known as the Annual Percentage Yield.
The money you earn from depositing your money into your savings account is used by the bank. They use your money to give loans to other people that is how you earn the revenue. The amount of interest rate totally depends on the credit worth. However, the more money you lend to clients or deposit in your account, the more revenue you will be able to generate.
How Does the Interest Rate work?
The borrower who has borrowed money, consumer goods, vehicles, or property is charged a fee to use that asset. This fee is paid to the lender for sacrificing the opportunity to use that money and take risks. Therefore, this money is termed as the interest rate, that is, the cost of money.
Some lenders lend money at a very high-interest rate, which makes borrowing cash really expensive. However, you have to pay interest on every loan transaction you make. There are a lot of people out there who take loans for their businesses, fund projects, tuition fees, or purchase homes.
The client has to pay the loan back along with the decided interest within a decided time. Some clients repay the loan either in a lump sum or in periodic installments. However, the borrowers can become heavily in debt if they are not able to pay the loan back on time.
Basic Formula to Calculate Interest
The most basic way to calculate interest is to multiply the principal by the interest rate.
Interest = Interest Rate X Principal or Balance
Types of Interest Rates
We have presented a comprehensive breakdown of different types of interest rates to make it easy for you to make informed financial decisions.
Simple Interest Rate
If you take a loan of $300,000 from a bank at an interest rate of 4%, then you will have to pay back $312,000 at the end of the year. If you have taken a loan of $300,000 for 30 years, then you will have to pay back $360,000.
- Simple interest = principal x interest rate x time
- Simple interest = $300,000 x 4% x 30 = $360,000
Compound Interest Rate
Certain lenders who want high interest on the amount they have landed to the borrowers typically opt for a Compound Interest Rate. The compound interest rate is also termed interest on interest, which is applied to accrued interest and principal interest. Moreover, the borrower owes the principal plus interest for the previous year.
Every year, the interest accumulating on both the initial principal and previous interest continues in a loop. This is why the compound interest rate accrues heavy debt for borrowers. You can find out the compound interest rate by the following formula.
- Compound interest = p x [(1 + interest rate)n 1]
- where:
- p = principal
- n = number of compounding periods
Fixed Interest Rate
In fixed interest rates the borrowers will be charged with a fixed interest rate that will not fluctuate over time. It does not depend upon the market interest rates; therefore, you will have to pay the same amount of payment over the entire term.
Borrowers who are expecting a rise in interest rates soon should lock their loans at a fixed rate when the interest rates are comparatively low. This way, your interest rate will remain stable even if the market rate gets high in the future.
Variable Interest Rate
A variable interest rate is the other way around to a fixed interest rate. It is charged according to the variation in market interest rates. The variable interest rate totally depends upon an underlying benchmark or index, like the federal funds rate.
As long as your payments are blended with principal and interest, your payments will fluctuate as well. Most people go for variable interest rate loans when they are applying for mortgages, credit cards, personal loans, derivatives, and corporate bonds.
Prime Interest Rate
Prime interest rates are set by banks for the best and most credit-worthy clients. Commercial banks set up a prime list of interest rates they would charge to their most financially strong customers. A wide range of banks offer prime interest rates to their clients.
However, the prime interest rate depends on the base interest rate, so it can vary. For instance, the base interest rate is 0.5% and the bank is offering a 3% interest rate to its regular clients. However, the prime interest rate will be 2%, which is offered to only prime clients of the bank.
Factors Affecting Interest Rates
- Inflation rate
- Economic condition of a state
- Government policies against central banks
- Supply and Demand
- International events
Conclusion
Interest rate plays a pivotal role in encouraging a dynamic society. Society has developed greater economic prosperity by allowing individuals to borrow and lend money on the basis of different types of interest rates. Capital is actively used by borrowers to fulfill their needs; however, lenders use it to earn revenue from their investments. We hope this article provides you with in-depth insights on interest rates.
