What Is Interest Rate? 

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Apart from this, the interest rate is also used to calculate the payment made to investors (debentureholders, bondholders, and preference shareholders). In practice, there are two types of rates of interest – simple and compound. Many economic parameters, like demand, money supply, consumer spending, etc., affect it.

Key Takeaways

  • Interest rates are the measures of calculating interest on a loan, deposit, or asset. Its common applications can be seen in computing the interest on a savings account, a mortgage loan, a consumer or personal loan, and even investing in bonds.There is two methods of computation – simple and compound interest. The latter is generally more profitable for the lender.Interest rates are important in an economy as it has the potential to control consumer expenditure, aggregate demand, and, thus, inflation.

Interest Rate Explained 

Interest rate is a significant financial and economic parameter. But first, let’s understand its role in finance. Lending and borrowing are common scenarios. The borrower receives the required amount to finance their requirements. But what does the lender receive? Interest – a kind of monetary compensation for the loan. Now, consider investments, especially debentures or bonds. The investor who contributes to raising capital, too, gets a share of the issuer’s profits. 

But how much interest does the lender receive? This is where the importance of interest rates comes in. It assigns a percentage of the principal sum, which one should pay to the lender at regular intervals. The lender and the borrower agree on the rate as both parties deem it advantageous.

Similarly, even in deposits made by customers, the interest rate on savings accounts helps customers benefit from holding their money with a bank. The bank can use the money to finance its other lending activities by paying a small interest to depositors.

Now, let’s move on to the role of interest rates in an economy. So often, an economy goes through different phases – inflation, disinflation, recession, etc. and the government has to find solutions to fix the situation. In such circumstances, the rate of interest can be a potential tool. 

For example, in periods of high inflation, a country’s central bank will implement a contractionary monetary policy to control consumer spending. One way to do this is an interest rate hike, through which people borrow less and consequently spend less. This affects the stock market, too, as the economy slows down, and investors would instead make higher returns from deposits than from securities. On the contrary, an expansionary monetary policy calls for a drop in borrowing rates.

Here, it is essential to understand the two main types of rates – APR and APY. The annual percentage rate (APR) is calculated on loans, whereas the annual percentage yield (APY), also known as the interest rate on savings accounts, is applicable for deposits. 

Formula 

Let’s look at how to compute simple and compound interest. The prerequisites for each method are the principal sum, time, and interest rate. 

#1 – Simple interest

It is a straightforward computation, and the borrower pays equal amounts in every installment. Therefore, simple interest is primarily beneficial to the borrower.

Simple interest = Principal sum x time x rate of interest

#2 – Compound interest

Here, the interest is compounded every time during an installment, and the calculation is a bit complex. Also known as interest on interest, compound interest computation favors lenders by giving them higher interest. Hence, it is more commonly used.

Compound interest = Principal Sum [( 1 + Rate of interest )Time – 1]

Points to remember:

– The time should be in years, and the interest rate as a decimal or fraction. This will facilitate more accessible and more accurate computation.

– Interest amount + Principal sum = Amount. (Amount refers to the net sum the borrower has to pay for the loan.)

Calculation Example

Scott borrowed a principal sum of $100,000 at 5% simple interest for three years. First, calculate the total interest and the net amount he will pay at the end of the loan.

Simple interest = 100,000 x 0.05 x 3 

= 15,000

This is the interest Scott will pay over three years. 

The total amount Scott will pay over the years for the loan of $100,000 is (100,000 + 15,000) = $115,000.

Now, calculate his monthly interest and total amount when compounded annually.

Compound interest = 100,000 [(1 + 0.05)3 – 1] 

= 15,762.5

The total amount paid for the loan at the end of 3 years is (100,000 + 15,762.5) = $115,762.5.

Hence, it can be seen that compound interest is greater than simple interest.

It is also possible to calculate interest using an online interest rate calculator.

This article has been a guide to what is Interest Rate and its meaning. Here, we explain simple and compound interest along with calculations, and example. You can learn more about it from the following articles –

Inflation is the rise in general price levels due to increased aggregate demand. When an economy is under high inflationary pressure (which is harmful to the country), the government and the central bank establish a contractionary monetary policy. As part of such a policy, commercial banks should raise their lending rates to discourage people from borrowing and spending. Thus, an interest rate hike restricts consumption, thus reducing demand and inflation.

No. Only the interest rates on loans are referred to as the annual percentage rate (APR). The rates on deposits or savings accounts are annual percentage yield (APY).

The interest rates are calculated as a percentage of the principal sum loaned or deposited. The rate depends on the sum, the time, and the nature of the investment/ asset/ loan. 

  • Variable Interest RateInterest Rate DifferentialFixed Interest Rate