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What is 'Interest Rate'

Interest rate is the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR). The assets borrowed could include, cash, consumer goods, large assets, such as a vehicle or building. Interest is essentially a rental, or leasing charge to the borrower, for the asset's use. In the case of a large asset, like a vehicle or building, the interest rate is sometimes known as the "lease rate". When the borrower is a low-risk party, they will usually be charged a low interest rate; if the borrower is considered high risk, the interest rate that they are charged will be higher.

BREAKING DOWN 'Interest Rate'

Interest is charged by lenders as compensation for the loss of the asset's use. In the case of lending money, the lender could have invested the funds instead of lending them out. With lending a large asset, the lender may have been able to generate income from the asset should they have decided to use it themselves.

Using the simple interest formula:

Simple Interest = P (principal) x I (annual interest rate) x N (years)

Borrowing $1,000 at a 6% annual interest rate for 8 months means that you would owe $40 in interest (1000 x 6% x 8/12).

Using the compound interest formula:

Compound Interest = P (principal) x [ ( 1 + I(interest rate) N (months) ) - 1 ]

Borrowing $1,000 at a 6% annual interest rate for 8 months means that you would owe $40.70.

The interest owed when compounding is taken into consideration is higher, because interest has been charged monthly on the principal + accrued interest from the previous months. For shorter time frames, the calculation of interest will be similar for both methods. As the lending time increases, though, the disparity between the two types of interest calculations grows.

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