What is interest rate

Interest

James Chen, CMT is an expert trader, investment adviser, and global market strategist. He has authored books on technical analysis and foreign exchange trading published by John Wiley and Sons and served as a guest expert on CNBC, BloombergTV, Forbes, and Reuters among other financial media.

What Is Interest?

Interest is the monetary charge for the privilege of borrowing money, typically expressed as an annual percentage rate (APR). Interest is the amount of money a lender or financial institution receives for lending out money. Interest can also refer to the amount of ownership a stockholder has in a company, usually expressed as a percentage.

Key Takeaways

Interest

Understanding Interest

Two main types of interest can be applied to loans—simple and compound. Simple interest is a set rate on the principal originally lent to the borrower that the borrower has to pay for the ability to use the money. Compound interest is interest on both the principal and the compounding interest paid on that loan. The latter of the two types of interest is the most common.

Some of the considerations that go into calculating the type of interest and the amount a lender will charge a borrower include:

APR includes the loan’s interest rate, as well as other charges, such as origination fees, closing costs, or discount points.

History of Interest Rates

This cost of borrowing money is considered commonplace today. However, the wide acceptability of interest became common only during the Renaissance.

Interest is an ancient practice; however, social norms from ancient Middle Eastern civilizations, to Medieval times regarded charging interest on loans as a kind of sin. This was due, in part because loans were made to people in need, and there was no product other than money being made in the act of loaning assets with interest.

The moral dubiousness of charging interest on loans fell away during the Renaissance. People began borrowing money to grow businesses in an attempt to improve their own station. Growing markets and relative economic mobility made loans more common and made charging interest more acceptable. It was during this time that money began to be considered a commodity, and the opportunity cost of lending it was seen as worth charging for.

Political philosophers in the 1700s and 1800s elucidated the economic theory behind charging interest rates for lent money, authors included Adam Smith, Frédéric Bastiat, and Carl Menger.

Iran, Sudan, and Pakistan use interest-free banking systems. Iran is completely interest-free, while Sudan and Pakistan have partial measures.   With this, lenders partner in profit and loss sharing instead of charging interest on the money they lend. This trend in Islamic banking—refusing to take interest on loans—became more common toward the end of the 20th century, regardless of profit margins.

Today, interest rates can be applied to various financial products including mortgages, credit cards, car loans, and personal loans. Interest rates started to fall in 2019 and were brought to near zero in 2020.

Special Considerations

A low-interest-rate environment is intended to stimulate economic growth so that it is cheaper to borrow money. This is beneficial for those who are shopping for new homes, simply because it lowers their monthly payment and means cheaper costs. When the Federal Reserve lowers rates, it means more money in consumers’ pockets, to spend in other areas, and more large purchases of items, such as houses. Banks also benefit from this environment because they can lend more money.

However, low-interest rates aren’t always ideal. A high-interest rate typically tells us that the economy is strong and doing well. In a low-interest-rate environment, there are lower returns on investments and in savings accounts, and of course, an increase in debt which could mean more of a chance of default when rates go back up.

A quick way to get a rough understanding of how long it will take for an interest-bearing account to double is to use the so-called rule of 72. Simply divide the number 72 by the applicable interest rate. At 4% interest, for instance, and you’ll double your investment in around 18 years (i.e., 72/4).

Types of Interest Rates

There are a variety of interest rates, which include rates for auto loans and credit cards. As of November 2020, the average auto rate for a five-year loan for a new car was 4.22%.   Meanwhile, for 30-year mortgages, the average fixed rate was 3.22%. 

The average credit card interest rates vary according to many factors such as the type of credit card (travel rewards, cashback or business, etc.) as well as credit score. On average, the interest rate for credit cards as of November 2020 was 16.03%. 

Your credit score has the most impact on the interest rate you are offered when it comes to various loans and lines of credit.

The subprime market of credit cards, which is designed for those with poor credit, typically carries interest rates as high as 25%. Credit cards in this area also carry more fees along with the higher interest rates and are used to build or repair bad or no credit.

Interest Rates Explained: Nominal, Real, Effective

What Are the Different Interest Rates?

The term “interest rate” is one of the most commonly used phrases in the fixed-income investment lexicon. The different types of interest rates, including real, nominal, effective, and annual, are distinguished by key economic factors, that can help individuals become smarter consumers and shrewder investors.

Key Takeaways

Nominal Interest Rate

Real Interest Rate

The real interest rate is so named, because unlike the nominal rate, it factors inflation into the equation, to give investors a more accurate measure of their buying power, after they redeem their positions. If an annually compounding bond lists a 6% nominal yield and the inflation rate is 4%, then the real rate of interest is actually only 2%.

Special Considerations

Several economic stipulations can be derived from this formula, which lenders, borrowers, and investors may utilize to cultivate more informed financial decisions.

Effective Interest Rate

Mathematically speaking, the difference between the nominal and effective rates increases with the number of compounding periods within a specific time period.

Forces Behind Interest Rates

Applications

The differences between nominal, real, and effective rates are important when it comes to loans. For example, a loan with frequent compounding periods will be more expensive than one that compounds annually, which is a vital consideration when shopping for mortgages.

Furthermore, a bond that pays just a 1% real interest rate may not adequately grow an investor’s assets over time. Simply put: interest rates effectively reveal the true return that will be posted by a fixed-income investment and the true cost of borrowing for individuals or businesses.

TIPS and Other Alternatives

Investors who seek protection from inflation in the fixed-income arena may elect to consider Treasury Inflation-Protected Securities (TIPS), which pay interest rates that are indexed to inflation.   Mutual funds investing in bonds, mortgages, and senior secured loans that pay floating interest rates, also periodically adjust with current rates.

The Bottom Line

When it comes to a bond’s interest rates, shrew investors know to look beyond nominal or coupon rates when considering their overall investment objectives. A qualified financial advisor can help investors navigate interest rates that keep up with inflation.

Interest Rate

What’s an Interest Rate?

An interest rate is the amount a borrower pays a lender to use the lender’s capital. It is typically given as an annual value or annual percentage rate (APR). The actual amount the borrower pays is determined by the amount of the loan, which is called the principal.

A lender usually charges a higher rate for a riskier loan. This is determined by the borrower’s credit, the period of time the borrower will be using the capital and the market alternatives available to both parties.

Calculating an Interest Rate Payment

The equation for calculating an annual interest rate payment is:

For a monthly payment:

Fixed Rates vs. Floating Rates

A floating interest rate can change as a function of a base rate that banks charge one another, e.g., LIBOR. In the example above, company XYZ may not want to make a commitment to a five year, fixed-rate loan.

Compound Interest

Compound interest is used when the payments of a loan or investment are added to the original principal instead of being paid out. The borrower avoids regular payments but will pay more interest when it’s time to pay off the loan. The lender or investor gives up the cash flow from regular payments, but earnings are amplified due to the increasing principal.

The formula for interest compounded yearly is:

If the loan is compounded monthly the formula is:

The equation for each payment, which is plowed back into the principal is:

A Guide to Interest Rates

When it comes to your finances, interest rates are actually a pretty interesting topic — especially when they help your money grow. A little interest can go a long way towards saving for a dream vacation, a down payment on a house or a remodel of your current place.

You might be wondering what the best savings account rates are or how interest is paid. You might also have questions about interest earned or interest paid.

If you’d like to learn a little bit more about interest rates and how they can work for you, you’re in the right place. This guide will help you make sense of interest rates, inflation and more.

What is an interest rate?

When you save money for the future by opening a savings account, the account’s interest rate is the rate your bank pays you for keeping your money with them. The money you earn on your savings is, naturally, the interest.

In contrast, if you borrow money — say to pay for a house or car — the interest is the fee you pay a lender for using their money over a period of time. When the loan is fully repaid, you will have paid the lender interest in addition to the original amount you borrowed (commonly referred to as the principal). The rate for your loan will indicate how much interest you will pay each month. The annual percentage rate (APR) will indicate the total interest over that year.

In a nutshell, it costs to borrow money and it pays to save. To learn more about different types of rates and how they are calculated, read on.

Calculating interest rates for saving

Interest works in your favor when you save. By earning interest on your deposits, you can increase the amount of money you end up with at the end of the saving period. Therefore, to better plan your savings goals, it helps to know how to calculate interest.

Simple interest vs. compound interest: What’s the difference?

You’ll want to know if the interest on your deposits and loans is simple or compound. Simple interest is calculated on the principal (original) amount of a loan. Compound interest on a deposit means each time the interest amount is calculated and added to the account, the cumulative balance earns interest. Bottom line: with compounding you earn interest on both your original money and on the interest the bank pays you each period to keep money in the account.

It’s important to find out how frequently interest is compounded for your savings account or loan: daily, weekly, monthly, semi-annually or annually. For a given annual rate on a savings account, the more compounding periods within a year, the higher your annual interest earnings will be. On a loan, more compounding periods in a year means the total amount you pay in interest will be higher that year.

Interest for high-yield savings accounts is typically compounded daily. In the example above, the interest was calculated using daily compounding.

To see how this works, check out the table below:

Interest Rate

Amount charged by a lender to a borrower for a debt

What is an Interest Rate?

An interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. The asset borrowed can be in the form of cash, large assets such as vehicle or building, or just consumer goods. In the case of larger assets, the interest rate is commonly referred to as the “lease rate.”

Interest rates are directly proportional to the amount of risk associated with the borrower. Interest is charged as compensation for the loss caused to the asset due to use. In the case of lending money, the lender could’ve invested the money in some other venture instead of giving it as a loan. In the case of lending assets, the lender could’ve generated income by making use of the asset himself. Thus, in return for these lost opportunities, interest rates are applied as compensation.

The annual interest rate refers to the rate that is applied over a period of one year. Interest rates can be applied over different periods, such as monthly, quarterly, or bi-annually. However, in most cases, interest rates are annualized.

Interest rate can also refer to the rate paid by the bank to its clients for keeping deposits in the bank.

Fixed vs. Floating (Variable) Rate

Interest rates can be fixed, where the rate remains constant throughout the term of the loan, or floating, where the rate is variable and can fluctuate based on a reference rate. More information regarding these two types of loan features can be found in the following article: Loan Features.

Cost of Borrowing

The interest expense – also known as the cost of borrowing money – can be classified into the following two types:

#1 Simple Interest

This type of interest is calculated on the original or principal amount of loan. The formula for calculating simple interest is:

#2 Compound Interest

Compound interest is calculated not just on the basis of the principal amount but also on the accumulated interest of previous periods. This is the reason why it is also called “interest on interest.” The formula for compound interest is as follows:

Unlike simple interest, the compound interest amount will not be the same for all years because it takes into consideration the accumulated interest of previous periods as well.

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Real and Nominal Interest Rates

A nominal interest rate is one with no adjustments made for inflation. In other words, regardless of the rate of inflation in the economy, the interest received, for example, on a deposit, will be the same even after a number of years.

The real interest rate takes the inflation rate into account. The repayment of principal plus the interest is measured on the basis of real terms compared against the buying power of the amount at the time it was borrowed, lent, invested, or deposited.

It’s important to factor in the effects of inflation on purchasing power because that’s the only way to know if you’re really earning a return from the interest being paid. For example, if you deposit money with a bank and earn a nominal 2% annual interest – if the inflation rate is 4%, then in terms of purchasing power, the money you have on deposit is actually losing 2% of its value every year.

The real rate of return on an interest-bearing account is the nominal interest rate MINUS the rate of inflation. The stated interest rate is just the “nominal” rate, meaning “in name only” – i.e., not the REAL rate being earned.

Factors Affecting Interest Rates

1. Forces of demand and supply

Interest rates are influenced by the demand for, and supply of, credit in an economy. An increase in demand for credit eventually leads to a rise in interest rates, or the price of borrowing. Conversely, a rise in the supply of credit leads to a decline in interest rates. The credit supply increases when the total amount of money that’s borrowed goes up.

For example, when money is deposited in banks, it is in turn used by banks for investment activities or to lend it elsewhere. As banks lend more money, there is more credit available, and thus borrowing increases. When this occurs, the cost of borrowing decreases (due to normal supply and demand economics).

2. Inflation

The higher the inflation rate, the higher interest rates rise. That is because interest earned on money loaned must compensate for inflation. As compensation for a decline in the purchasing power of money that they will be repaid in the future, lenders charge higher interest rates.

3. Government

In some cases, the government’s monetary policy influences the amount of interest rates. Also, when the government buys more securities, banks are injected with more money to be used for lending, and thus interest rates decrease. When the government sells these securities, money from the banks gets drained, giving banks less money for lending purposes and leading to a rise in interest rates.

Related Readings

Thank you for reading this guide to Interest Rates. To continue advancing your career, these additional CFI resources will be helpful: