Types of Interest

Updated on April 12, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

List of Top 7 Types of Interest

  1. Fixed Interest Rate
  2. Variable Interest Rate
  3. Annual Percentage Rate
  4. Prime Interest Rate
  5. Discounted Interest Rate
  6. Simple Interest Rate
  7. Compound Interest Rate

Key Takeaways

  • The types of interest are fixed interest rate, variable interest rate, annual percentage rate (APR), prime interest rate, discounted interest rate, simple interest rate, and compound interest rate.
  • When borrowing money, the debt has two components: the principal, which is the amount borrowed, and the interest, which is an additional charge representing the cost of borrowing and serves as income for the lender.
  • Compound interest is calculated based on the loan’s principal and accrued interest. Banks typically apply the interest to the loan balance, and the remaining balance is used to determine the next period’s interest payment, creating a compounding effect over time.

Debt comes from two components, i.e., principal and interest. The principal is the actual sum of money borrowed by the business or individual, and the interest is the additional charges, which are, in a way, a form of income for the lender to provide the debt.  Interest comes in various forms, and its primary types include Fixed Interest, Variable Interest, Annual Percentage Rate, Prime Interest Rate, Discounted Interest Rate, Simple Interest, and Compound Interest.

Types of Interest

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#1 – Fixed Interest Rate

A fixed interest rate is the most common type of interest rate, which is generally charged to the borrower of the loan by lenders. As the name suggests, the interest rate is fixed throughout the loan’s repayment period. It is usually decided on an agreement basis between the lender and the borrower when the loan is granted. This is much easier, and calculations are not at all complex.

  • It gives a clear understanding to the lender and the borrower what the exact amount of interest rate obligation is associated with the loan.
  • Fixed interest is a rate that does not fluctuate with time or during the loan period. This helps in the accurate estimation of future payments to the borrower.
  • Though one drawback of a fixed interest rate is that it can be higher than variable interest rates, it eventually avoids the risk that a loan or mortgage can get costly.

Example

A fixed interest rate can be a borrower who has taken a home loan from a bank/lender for a sum of $100000 at a 10% interest rate for a period of 15 years. This means the borrower for 15 years must bear 10% of $100000 = $10000 every year as the interest payment. Thus, with the principal amount constantly every year, he has to pay $10000 for 15 years. Thus, we see no change in the rate of interest and the interest amount which the borrower has to repay the bank. Thus, it makes it easy for the borrower to plan his budget accordingly and make the payment.

#2 – Variable Interest Rate

A variable interest rate is just the opposite of a fixed interest rate. Here the interest rate fluctuates with time. Variable-rate interest is generally linked to the movement of the base level of interest rate, which is also called the prime rate of interest. Borrowers end up on the winning side if the loan has opted on a variable rate of interest basis, and the prime lending rate decreases.

Example

Suppose the borrower is given a home loan for 15 years, and the loan amount sanctioned is $100000 at a 10% interest rate. The contract is set as for the first five years, the borrower will pay a fixed rate of 10 %, i.e., $10000 years, whereas, after five years, the interest rate will be on a variable basis assigned to the prime interest rate or base rate. Now suppose after five years, the prime rate increases, which eventually increases the borrowing rate to 11 %. Thus now the borrower pays $11,000 yearly, whereas if the prime rate falls and the borrowing rate becomes 9%, the borrower in such a scenario saves money and only ends up paying $9,000 yearly.

#3 – Annual Percentage Rate

Annual Percentage Rate is very common in credit card companies and credit card mode of payment methodology. Here the annual rate of interest is calculated as the amount of the total sum of interest pending, which is expressed on the total cost of the loan.

  • Credit card companies will apply this method when customers carry their balance forward instead of repaying it fully. The calculation of the annual percentage rate is expressed as the prime interest rate; along with this, the margin that the bank or lender charges are added upon.

Example

Suppose we have a credit card with a 24% APR. It means for 12 months, we are charged at a rate of 2% per month. Now all months won’t have equal days; thus, APR is further divided by 365 days or 0.065%, which is called the DPR. Thus interest rate finally stands for DPR or the daily rate multiplied by the daily card balance, and then further, this result is multiplied by the number of days in the billing cycleBilling CycleThe billing cycle is the time period between one billing statement and the next billing date that companies generate for its services and products sold to the customers. The cycle could be monthly, quarterly or even annually. read more.

#4 – Prime Interest Rate

The prime rate is the rate the banks generally give to their favored customers or customers with a very good credit history. This rate is generally lower than the usual lending/borrowing rate. It is generally linked to the Federal Reserve lending rate, the rate at which different banks borrow and lend. But again, not all customers will be able to opt for this loan.

Example

Suppose when a big corporation has a regular loan history and very good repayment history, too, with the bank approaching the lender for a short term loanShort Term LoanShort-term loans are defined as borrowings undertaken for a short period to meet immediate monetary requirements.read more, the bank can arrange for the same at a prime rate and offer it to its customer as a good gesture of relationship.

#5 – Discounted Interest Rate

This interest rate does not apply to the common public. This rate is generally applicable for Federal Banks to lend money to other financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more on a short-term basis, which can be as short as a single day. Banks may opt for such loans at a discounted rate to cover up their lending capacity, rectify liquidity problems, or prevent a bank from failing in a crisis.

Example

Suppose, at times when the loans/lending becomes more than deposits in a single day, a particular bank may approach the Federal Bank to grant loans at a discounted rate to cover up their liquidity or lending position for the day.

#6 – Simple Interest Rate

Simple InterestSimple InterestSimple interest (SI) refers to the percentage of interest charged or yielded on the principal sum for a specific period.read more is a bank’s rate of interest for charging its customers. The calculation is basic and generally expressed as the multiplication of principal, interest rate, and the number of periods.

Example

Suppose a bank is charging a 10% rate of interest on a loan for $1000 for three years; the simple interest calculation stands to be $1000 * 10% *3 = $300.

#7 – Compound Interest Rate

Compound InterestCompound InterestCompound interest is the interest charged on the sum of the principal amount and the total interest amassed on it so far. It plays a crucial role in generating higher rewards from an investment.read more methodology is called interest on interest. Banks generally use the calculation to calculate the bank rates. It is based on two key elements: the interest of the loan and the principal amountLoan And The Principal AmountLoan Principal Amount refers to the amount which is actually given as the loan from the lender of the money to its borrower and it is the amount on which the interest is charged by the lender of the money from the borrower for the use of its money.read more. Here banks will first apply the interest amount on the loan balance, and whatever balance is pending will use the same amount to calculate the subsequent year’s interest payment.

Example

For example, we have invested in the bank for $1000 at 10% interest. First-year we will earn $100 and second-year the interest rate will be calculated not on $10,000 but on $10,000 + $100 = $10,100. Thus we will earn slightly more than what we would have earned under a simple interest format.

Frequently Asked Questions (FAQs)

1. Which type of interest makes the most money? 

The type of interest that generates the most money depends on various factors, including the initial investment, interest rate, compounding frequency, and investment duration. Compound interest often yields more substantial returns over time than simple interest. Investments like stocks and mutual funds can yield higher returns than traditional savings accounts due to their potential for capital appreciation and compounding gains.

2. What type of interest makes your money grow faster? 

Compound interest is the type of interest that accelerates your money’s growth. In compound interest, the interest earned is added to the initial investment, and subsequent interest is calculated based on this higher total. Over time, this compounding effect results in exponential growth. 

3. What is the importance of the existence of different types of interest rates? 

Different types of interest rates serve several vital purposes in the financial world. Central banks use benchmark interest rates, like the federal funds rate in the U.S., to influence economic conditions, including inflation and borrowing costs. Lenders and borrowers utilize prevailing interest rates to determine the cost of borrowing and the potential returns on investments. Different types of interest rates cater to various financial needs, from saving money to making investments, and play a crucial role in shaping economic decisions on both individual and macroeconomic levels.

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