The interest rate is the percentage that shows how much interest is charged on the principal amount. It represents what lenders ask from borrowers or what you earn from your savings.
When it comes to loans, the interest rate is usually shown on a yearly basis and is referred to as the annual percentage rate (APR).
Interest rates also apply to savings accounts or certificates of deposit (CDs). Here, banks or credit unions pay account holders a percentage of the money they deposit. The annual percentage yield (APY) indicates the interest earned on these types of accounts.
Learn more about Interest Rate
In lending, interest is basically the fee that borrowers pay for using someone else’s asset. This can include things like cash, cars, consumer goods, or real estate. So, you can think of the interest rate as the “price of borrowing money.” When interest rates go up, it makes borrowing the same amount of cash more costly.
Interest rates are a part of most lending or borrowing deals. People often take out loans to buy homes, support projects, start or grow businesses, or cover college expenses. Companies also borrow money to invest in capital projects and expand by acquiring long-term assets like land, buildings, and machinery. Borrowers typically pay back the money either all at once by a set date or in regular installments.
For loans, the interest rate is applied to the principal, which is the initial loan amount. This rate represents the cost of borrowing for the borrower and the return on investment for the lender. Usually, the total amount repaid is higher than what was borrowed because lenders expect to be compensated for not being able to use that money during the loan period. They could have invested it elsewhere to earn income. The difference between what you repay and the original loan amount is the interest.
If a lender sees a loan as low risk, they usually offer a lower interest rate. Conversely, if the loan is deemed high risk, the borrower will face a higher interest rate.
Simple Interest Rate
Simple interest = principal x interest rate x timeIf you borrow $300,000 from the bank and the loan terms say the interest rate is 4% simple interest, you’ll end up paying back the original $300,000 plus $12,000 in interest. So, in total, you’ll owe the bank $312,000.
Compound Interest Rate
\(\textbf{Compound interest} = \text{p}\text{ x }\left[ \left( 1+\text{interest rate} \right)^{n}-1 \right]\)where:
p = principal
n = number of compounding periodsSome lenders like to use the compound interest method, which means borrowers end up paying more in interest. Compound interest, often referred to as “interest on interest,” is calculated on both the original amount borrowed and the interest that has built up over time. So, by the end of the first year, the borrower owes the original amount plus the interest for that year. Then, by the end of the second year, they owe the original amount, the first year’s interest, and the interest on that first year’s interest.
When it comes to compounding, the interest adds up to more than what you’d pay with simple interest. Interest is charged monthly on the principal, which includes any interest that has already accrued. For shorter loan periods, the interest calculations for both methods are pretty similar. However, as the loan term gets longer, the difference between the two methods becomes more pronounced.
For instance, after 30 years, a $300,000 loan at a 4% interest rate could rack up nearly $673,019 in interest.
Conclusion
An interest rate represents the expense of borrowing for the borrower and the earnings for the lender. When you borrow money, you’re required to pay back a little more than what you took out as a form of compensation to the lender. On the flip side, if you put money into a savings account, the bank might give you some extra cash because they can use a portion of your deposit to lend to other customers. These extra amounts are known as interest and are calculated at a certain rate.