What Is Interest Rate?
Interest rate in finance refers to the amount owed on a loan or a deposit as a percentage of the principal amount. It depends on the principal amount and the time. It helps to compute the interest, which is monetary compensation to the individual who loans or deposits the money.
Apart from this, the interest rate is also used to calculate the payment made to investors (debenture holders, 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.
Table of contents
- 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 federal interest rate 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 under the federal interest rate. 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.
Let’s look at how to compute simple and compound interest. The prerequisites for each method are the principal sum, time, and interest rate which is applicable for home loan interest rate or any other borrowings.
#1 – Simple interest
Simple interest = Principal sum x time x rate of interest
#2 – Compound interest
Here, to calculate interest rate, 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.)
Let us understand how to calculate interest rate, using some suitable examples.
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
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]
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.
In this context, it is important to note that this concept of under the federal interest rate plays a very significant role from the point of view of both borrowers and lenders. In case of borrowing, if the rate is low, then the borrowing cost will be low, making it easy for the borrowers to repay the loan without much of a hassle and tension regarding the liability. But high rate will not only discourage borrowers from taking loans but also make the repayment process tough. If loans are given to individuals or corporates at high rates that is beyond the credit repayment capacity of the borrower, it often results in bad debts, which affects the cash inflow, asset level and profitability of the lenders.
From the above explanation it can be easily derived that in case of deciding the home loan interest rate, lenders should pay special attention while lending and not just try to quote high rates to earn good return. If rates are high, lenders should analyse the credit rating of the borrowers to prevent losses due to bad debts.
It should also be noted that very high interest rates may reduce demand for loans, which in turn will lead to lack of financial resource mobilization and lack of investment. This means the economy may not be able to advance towards and better future. Therefore every country’s policymakers should be prompt enough to frame financial policies regarding rates and implement them in such a way so that there is optimum use of resource with minimum risk.
Similar to every other type of financial procedures and concepts, interest rate also involves an element of risk, which needs to be accounted for while studying and analysing interest rate for mortgage for any decision making. The risk in this regard is the possibility to incur losses in investment opportunity.
In the financial market, interest is the main element of bonds or any fixed income investment. They are value based on the interest levels they provide to the clients. In such a case, if the interest falls, the value of both the above existing instruments will reduce. People mainly go for fixed income opportunity because of the fair level of interest that they get from it along with very limited risk. But if the interest is below their expectations, then, their demand will reduce, resulting in fall in value of the new ones.
Similarly, for bonds, if the existing clients are getting good interest levels from the bonds that they are currently holding and if the rates suddenly falls, the value of new bonds in the market will reduce. Similarly, when interest rates rise, the bonds with old and lower rates will be less appealing to clients. Therefore bondholders should clearly understand and analyse the rates before making investments.
The risks involving to interest related to different instruments can be curbed through portfolio diversification or hedging. Duration also plays a role in interest risk. The longer duration financial instruments will have to bear the risk longer, thus, making it less valuable in the market, whereas short duration instruments will be priced higher. However, due to this higher interest rate risk of long term bonds, their return expectation is also higher.
Interest Rate Vs Annual Percentage Yield(APY)
Even though very often the above two terms are replaced by each other or used interchangeably, there are some significant differences between them, which are as follows:
- Even though both are expressed in percentage form, the former is the rate that gives us the amount that the original amount of the investment earns periodically. But the latter refers to the total amount of interest that the investment has earned over the entire financial year expressed in percentage.
- The interest rate for mortgage does not include the element of compound interest in it. It just calculates a single interest amount. But the latter included the compounded interest value, which is the interest earned in the previous interest and the principal taken together.
- The former is just a part of a component of the latter. Therefore, the former is the rate earned in savings, or investment and paid on mortgage loans. But the latter is the total interest earned over a one-year period.
- The latter is more commonly used by financial institutions to advertise and market about their savings account schemes, because it portrays a more lucrative return amount to the prospective customers.
- Customers always look for a higher value of the latter because it will signify that the invested amount will increase at a higher pace. The former does not signify so.
Thus, the above are some noteworthy and significant differences between the two concepts.
Frequently Asked Questions (FAQs)
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.
This article has been a guide to what is Interest Rate. We explain its formula and differences with annual percentage yield along with risk & example. You can learn more about it from the following articles –