The interest rate is the amount charged by the lender for the use of assets by the borrowers. The borrowed assets can be cash, assets, buildings, vehicles, or consumer goods. It is expressed as a percentage of the principal and is typically noted on annual basis also known as the annual percentage rate (APR).
Now there are two types of interest rates, the nominal and the real rate.
The real interest rate is the one that has been adjusted to take inflation into account on the prices and therefore represent the real cost of funds to the borrower (the one who is paying it). Hence, it represents the real yield to the lender (the one who receives the interest rate payable) or to an investor. In other words, it adjusts for inflation and gives the real rate of a bond or a loan. In order to calculate the real interest rate, you first need to calculate the nominal minus the expected or actual inflation rate.
The nominal interest rate refers to the one before taking into account inflation. Short-term nominal rates are set by central banks and are the basis for other interest rates that are charged by the banks or institutions. If central banks decide to keep nominal rates low, it is because they want to boost economic activity. Low nominal rates encourage consumers to take on more debt and increase their spending.
FACT: This is what followed after the financial crisis in 2008 when the U.S. Federal Reserve dropped its Fed Funds Rate to 0-0.25% and remained this low for 7 years until 2015.
Interest is a simple term for a rental or leasing charge and is usually determined by the risk. For example, when the borrower is considered to be low risk by the lender, he will then charge the borrower a lower interest rate. However, if the lender thinks that the borrower is a high risk, he will charge a higher interest rate. This risk is assessed by looking at the borrower’s background or credit score, which is why it is important to have an excellent one if you want to qualify for the best loans.
An individual takes out a $300,000 mortgage from the bank with an interest rate on the agreement of 15%. The borrower will have to then pay the bank $300,000 (the original loan amount) and an additional ($300,000 * 15%) $45,000 totaling $345,000.
Sounds fair enough up to hear right? Well, this $45,000 is the interest rate at the annual rate on the lending agreement. If the agreement was for 20 years, the interest payment will be $45,000 * 20 = $900,000 which explains how banks make their money.
Compound interest is basically interest on interest and is preferred to some lenders because borrowers pay more in interest rates. It is applied to the principal but also to the accumulated interest of previous periods.
The illustration shows how compound interest works.
Year | Beginning Loan | Interest 15% | Ending Loan |
1 | $200,000 | $30,000 | $230,000 |
2 | $230,000 | $34,500 | $264,500 |
3 | $264,000 | $39,675 | $303,675 |
4 | $303,675 | $45,551.25 | $349,226.25 |
5 | $349,226.25 | $52,383.9375 | $401,610.188 |
6 | $401,610.188 | $60,241.5285 | $461,851.716 |
7 | $461,851.716 | $69,277.7574 | $531,129.473 |
At the end of 7 years, the total amount owed is $531,129.473 on a $200,000 loan. Another method to calculate compound interest rate is by using the following formula:
px[( 1+interest rate)n = Compound Interest
Where:
P = principal
N = number of compounding periods
There is also a favorable compound interest rate when it comes to an entity saving money using a savings account. The interest earned on these accounts is compounded and is compensation to the account holder for allowing the bank to use the deposited funds. If a business deposits $850,000 into a high-yield savings account, the bank can take $400,000 of these funds to use as a mortgage loan.
In return for borrowing these funds the bank will pay let’s say a 6% interest into the account annually. So, while the bank is taking 15% from the borrower, it is giving 6% to the business account holder, or the bank’s lender, netting it 9% in interest. In effect, savers lend the bank money, which, in turn, provides funds to borrowers in return for interest.
TIP: The snowballing effect of compounding interest rates, even when rates are at rock bottom, can help you build wealth over time
The interest rates charged by banks are determined by a number of factors. As mentioned above, a country’s central bank sets the interest rates which each bank will then use to determine the annual percentage rate they offer. High-interest rates set by central banks increase the cost of debt and therefore, discourage people from taking on loans and slows the overall economy.
Another factor is inflation. In order to combat this, banks might set higher reserve requirements and tight money supply. In a high-interest rate economy, people resort to saving their money since they receive more from the savings rate. In this case, the stock market suffers since investors would rather take advantage of the higher rate from savings than invest in the stock market with lower returns. Businesses also face a problem with funding through debt, which leads to economic contraction.
Spending fuels the economy and leads a country to economic expansion. This is accomplished with low-interest rates that encourage people to take on loans and therefore spend more.
Why don’t you try learning about Contract for differences now?
