An interest rate is an amount a lender charges a borrower when applying for a loan. Usually, this amount is taken from a percentage of the principal amount borrowed. It’s also usually depicted as Annual Percentage Rate (APR), derived from calculating the interest you’ll have to pay per year.
An interest rate could also be applied to the amount of money you earned from investing in a bank or a credit union, usually in the form of a savings account called Annual Percentage Yield (APY).
How Does It Work?
Interest rate commonly means the amount of money an individual pays for using an asset. This asset can mean consumer goods, money, property, equipment, and vehicles.
You can think of it this way: the cost of money we’re borrowing. Sometimes, when we want something, we have no money to purchase it. That said, people often look for lending companies that offer loans so that they can purchase products like vehicles and houses, invest in their businesses, or pay for education.
When applying for a loan, the lender lets an individual borrow money in exchange for something, usually money in the form of interest rate.
As mentioned earlier, the interest rate is calculated from the principal amount of the loan. However, there are also other factors like the borrower’s creditworthiness, credit history, etc. Usually, the interest rate is much lower when the borrower is low risk. However, when the borrower is at high risk, the interest rate is higher than usual.
But why? This is to offset the risk of losing money. Remember, you’re borrowing a massive amount of money; if you can’t repay it, it’s a huge loss for them. To preemptively take back that considerable loss, they take it in the form of a high interest rate.
There are a few types of interest rates you should know. Here are some of them.
Simple Interest Rate
This one is straightforward to understand. Suppose you borrowed $300,000 from the bank and the agreed interest is 4%. This means that for you to repay them and close the loan, you would have to pay $300,000 + 4% of the interest, which is $12,000.
The $12,000 is derived by multiplying 0.04 by 300,000. This is the formula, assuming that the agreed loan only takes a year to be repaid.
Simple Interest = Principal X Interest Rate X Time
In a year, that 4% would translate to $12,000, which is the bank’s profit. After 30 years, the borrower would have paid back $360,000 in interest payments, which is how banks make their money.
Compound Interest Rates
Some lenders in the market prefer to use a compound interest rate, which in layman’s terms, means that the borrower would even have to pay more interest. Compound interest, commonly known as interest on interest, is applied to your principal and your accumulated interest rate during your previous periods.
In this case, the bank assumes that after the first year, the borrower owes them the principal and the interest. In the second year, the bank would expect you to pay for another interest on the principal and its interest in the first year and interest for the first year. Compounding interest usually ends up in paying for more than your loan originally had.
Short-term loans with compounding interest are usually similar to simple interest, but as the loan matures, the disparity between them can be apparent.
For example, let’s use the one above but with a 30-year agreement. The total owed in interest would be $700,00 on a $300,00 with a 4% interest rate. In short, the difference between simple interest and compound interest is that you pay more interest with compound interest.
Here’s the formula:
Compound interest = p X [(1 + interest rate)ᶰ− 1]
p = principal
n = number of compounding periods
Compound Interest and Savings Account
In savings accounts, compounding is the common method for banks to grow their client’s money. This is their payment for letting them use the money on your account for their interests. So how does it work? Let’s have an example.
Suppose you have deposited $500,000 into your savings account. The bank can use $300,000 on that for another person’s mortgage with a $4 interest rate. The 1% of that interest rate will be deposited back into your account while they take the other 3%. In essence, you’re lending your money to the bank while they give you back a percentage of what they’re using it for in return as compensation.
Interest rates are more complicated than you think when you think about how they are calculated. But it’s pretty easy to understand when you think about them as something we have to pay for borrowing their assets. However, that doesn’t change the fact that it’s additional money that we have to pay. We’re borrowing an asset from the bank, after all.