Types of Interest

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

Debt comes in the form of 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 rate of interest is fixed throughout the repayment period of the loan and is usually decided on an agreement basis between the lender and the borrower at the time of granting the loan. This is much easier, and calculations are not at all complex.

  • It gives a clear understanding both to the lender and the borrower what is the exact amount of interest rate obligation, which is associated with the loan.
  • Fixed interest is a type of interest rate where the rate does not fluctuate with time or during the period of the loan. This helps in accurate estimation of future payment to be made by the borrower.
  • Though one drawback of 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 for a period of time.

Example

A fixed-rate of interest can be a borrower who has taken a home loan from a bank/lender for a sum of $100000 at a 10% rate of interest 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 along with the principal amount on a constant basis every year, he has to make to payment of $10000 for 15 years. Thus, we see that there is 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 if 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.

  • In this case, the borrowing rate also goes down. This generally happens when the economy is passing through a crisis situation. On the other hand, if the base interest rate or the prime interest rate rises, the borrower is forced to pay a higher rate of interest in such scenarios. Banks will purposely do such to safeguard themselves from interest rates as low as that the borrower ends up giving payments, which are comparatively lesser than the market value of the interest for the loan or debt.
  • Similarly, the borrower has an added advantage when the prime rate of interest falls after a loan is approved. The borrower does not have to overpay for the loan with the variable rate, which is assigned to the prime interest rate.

Example

Suppose if the borrower is given a home loan for a period of 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 the period of 5 years, the interest rate will be on a variable basis assigned to the prime interest rate or base rate. Now suppose after 5 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 the credit card companies and credit care 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 a customer carries forward their balance instead of repaying it fully. The calculation of the annual percentage rate is expressed as the prime interest rate, and along with this, the margin which the bank or lender charges is added upon.

Example

Suppose we have a credit card with 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 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 cycle.

#4 – Prime Interest Rate

The prime rate is the rate that is generally given by the banks to its favored customers or with 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, which is 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 corporate has a regular loan history and very good repayment history too with the bank approaches the lender for a short term loanShort Term LoanShort term loans are the loans with a repayment period of 12 months or less, generally offered by firms, individuals or entrepreneurs for immediate liquidity requirements. These are usually provided at a higher interest rate, these short term loans often have a weekly repayment schedule.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 is not applicable 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 in crisis times to prevent a bank from failing.

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 Interest is the rate of interest that a bank does for charging its customers. The calculation is very basic and is generally expressed as the multiplication of principal, interest rate, and the number of periods.

Example

Suppose a bank is charging 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 earned from the initial Principal & the previously accumulated Interest amount. This is also known as “Interest on Interest” & it is always higher than the Simple Interest. read more methodology is called interest on interest. The calculation is generally used by banks to calculate the bank rates. It is basically made on two key elements, which are the interest of the loan and the principal amountLoan And The Principal AmountLoan Principal Amount refers to the amount of money loaned by the lender to the borrower. Furthermore, it is the amount on which the lender charges the borrower interest for fund utilization.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

Let us take an example where we have made an investment 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 simple interest format.

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This has been a guide to Types of Interest and its definition. Here we discuss the list of top 7 types of interest with examples and detailed explanations. You may learn more about financing from the following articles –

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