Interest Rate

AAA

DEFINITION of 'Interest Rate'

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.

INVESTOPEDIA EXPLAINS '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.

VIDEO

Loading the player...
RELATED TERMS
  1. Nominal Interest Rate

    The interest rate before taking inflation into account. The equation ...
  2. Lock Period

    A number of days, often 30 or 60, during which the interest rate ...
  3. Federal Open Market Committee - ...

    The branch of the Federal Reserve Board that determines the direction ...
  4. Alan Greenspan

    The former chairman of the Board of Governors of the Federal ...
  5. Fixed Interest Rate

    An interest rate on a liability, such as a loan or mortgage, ...
  6. Interest Rate Ceiling

    The maximum interest rate that a financial institution can charge ...
RELATED FAQS
  1. What are the main risks to the economy of a country that has implemented a policy ...

    The main risk to the economy of a country that has implemented a policy of austerity is the potential for a self-reinforcing, ... Read Full Answer >>
  2. What are the similarities and differences between the savings and loan (S&L) crisis ...

    The savings and loan crisis and the subprime mortgage crisis both began with banks creating new profit centers following ... Read Full Answer >>
  3. What major events and policy decisions led to the savings and loan crisis (S&L crisis)?

    The major events and policy decisions that led to the Savings and Loan Crisis were a period of volatility for interest rates ... Read Full Answer >>
  4. Which economic factors impact treasury yields?

    The economic factors that impact Treasury yields are interest rates, inflation and economic growth. All of these factors ... Read Full Answer >>
  5. Why have austerity policies failed to stabilize Greece's economy?

    Austerity policies are intended to reduce government debt and bring stability to that nation's economy. Austerity's effectiveness ... Read Full Answer >>
  6. What are some examples of positive correlation in technical stock market analysis?

    Some examples of positive correlation in technical stock market analysis are the relationship between commodity-producing ... Read Full Answer >>
  7. What credit rating should I look for in an oil and gas company?

    Look for a credit rating in an oil and gas company that is suitable for your desired returns and risk tolerance level. Companies ... Read Full Answer >>
  8. In what situations would a loan to an S Corporation from one of its principals be ...

    When a principal of an S corporation pays money into the business, vastly different tax consequences exist depending on whether ... Read Full Answer >>
  9. What economic indicators should be monitored when investing in the industrial sector?

    The major economic indicators to monitor when investing in the industrial sector are economic growth, interest rates and ... Read Full Answer >>
  10. What is the relationship between equity spot prices, dividends, and future stock ...

    The relationship between equity spot prices, dividends and future stock prices is straightforward in the near-term. The difference ... Read Full Answer >>
  11. Are there Exchange Traded Funds (ETFs) that offer a high bond yield?

    There are many exchange-traded funds (ETFs) that offer high bond yields. Some of the most liquid and widely traded are the ... Read Full Answer >>
  12. What are some common examples of demand shock?

    Common examples of demand shocks are interest rate cuts, tax cuts, government stimulus programs, natural disasters, terrorist ... Read Full Answer >>
  13. How have low interest rates affected the real estate sector?

    Low interest rates stimulate the real estate sector by encouraging home-buying activity and by making it less expensive for ... Read Full Answer >>
  14. What economic indicators are important to consider when investing in the chemicals ...

    The most important economic indicators to consider when investing in the chemicals sector are economic growth, interest rates, ... Read Full Answer >>
  15. What are the primary factors that drive share prices in the chemicals sector?

    The primary factors that drive share prices in the chemicals sector are interest rates, inflation, economic growth and earnings. ... Read Full Answer >>
  16. What economic indicators are important to monitor when investing in the insurance ...

    Inflation and interest rates are the best economic indicators to monitor when investing in the insurance sector. Unlike with ... Read Full Answer >>
  17. What is the difference between the rule of 70 and the rule of 72?

    The rule of 70 and the rule of 72 give rough estimates of the number of years it would take for a certain variable to double. ... Read Full Answer >>
  18. What is the average profit margin of a company in the chemicals sector?

    Macaulay duration and modified duration are used in fixed income markets to determine a bond's duration. The Macaulay duration ... Read Full Answer >>
  19. What are the differences between a bond's yield to maturity and the spot rate?

    One should expect income when buying stocks in the consumer packaged goods sector. This sector is considered a defensive ... Read Full Answer >>
  20. What are the typical day-to-day responsibilities of a Chief Operating Officer (COO)?

    A country's debt crisis affects the world through a loss of investor confidence and systemic financial instability. A country's ... Read Full Answer >>
  21. How can I calculate compounding interest on a loan in Excel?

    Compound interest is the amount of interest on a principal amount, along with the accumulated interest on the principal from ... Read Full Answer >>
  22. What formula can I use to calculate interest on interest?

    Use the compound interest formula to determine the amount of accumulated interest on the principal amount invested or borrowed. ... Read Full Answer >>
  23. How does the division of regional and national banks affect investing in the banking ...

    Investors looking at the banking sector have a choice to either invest in large national banks that provide a higher degree ... Read Full Answer >>
  24. How do I calculate how long it takes an investment to double (AKA 'The Rule of 72') ...

    You can calculate the approximate amount of years it would take an investment to double, given the annual expected rate of ... Read Full Answer >>
  25. How can central banks use open market operations to manipulate short-term interest ...

    A central bank uses open market operations to manipulate short-term interest rates by increasing or decreasing the money ... Read Full Answer >>
  26. Under what circumstances might an issuer redeem a callable bond?

    The primary circumstance under which a bond issuer redeems a callable bond is a drop in interest rates. When rates fall, ... Read Full Answer >>
  27. How can I use interest rates to indicate the right time to buy a cyclical stock?

    Interest rates can be used to indicate the right time to buy a cyclical stock based on whether they are increasing or decreasing. ... Read Full Answer >>
  28. What are the differences between debit cards and credit cards?

    Debit cards and credit cards work in similar ways. Both carry the logo of a major credit card company, such as Visa or MasterCard, ... Read Full Answer >>
  29. What is the relationship between national interest rates and the amount of revolving ...

    National interest rates and the amount of revolving credit issued have a negative relationship. Interest rates rise due to ... Read Full Answer >>
  30. How does lower borrowing costs affect new airlines in the aerospace industry?

    Lower borrowing costs can help a new airline afford to obtain aircraft as well as pay for operating expenses such as salaries ... Read Full Answer >>
  31. What factors are the primary drivers of share prices in the internet sector?

    Economic conditions such as interest rates, unemployment and wage growth drive share prices in the Internet sector. This ... Read Full Answer >>
  32. How can an investor reduce interest rate risk?

    Investors can reduce interest rate risk with forward contracts, interest rate swaps and futures. Investors may desire reduced ... Read Full Answer >>
  33. What is the relationship between modified duration and interest rates?

    Modified duration is a formula that measures the value of a bond in relation to changes in interest rates. Modified duration ... Read Full Answer >>
  34. How have low interest rates affected lease rates in the automotive sector?

    Low interest rates have contributed substantially to increased lease rates in the automotive sector. In recent years, the ... Read Full Answer >>
  35. How do interest rate changes affect the profitability of the banking sector?

    The banking sector's profitability increases with interest rate hikes. Institutions in the banking sector such as retail ... Read Full Answer >>
  36. What are the biggest risks of fixed-income investing?

    The biggest risks of bonds and other fixed-income investments are interest rate risk, credit risk and inflation risk. There ... Read Full Answer >>
  37. How does the law of supply and demand affect the stock market?

    The law of supply and demand affects the stock market by determining prices of the individual stocks that make up the market. The ... Read Full Answer >>
  38. When did people first start using collateral to secure loans?

    The history of lending, particularly non-money lending, is not well documented. It is widely believed among financial historians ... Read Full Answer >>
  39. How can I tell if a loan uses simple or compound interest?

    When analyzing the terms of a loan, it is important to consider more than the interest rate. Two loans can have identical ... Read Full Answer >>
  40. How do investment banks help the economy?

    There are two broadly recognized functions of investment banks: capital market intermediation and trading. These are distinct ... Read Full Answer >>
  41. How can investors use trends in the unemployment rate to evaluate the outlook of ...

    Credit services companies provide financial services in the form of credit and loans to individuals and businesses; these ... Read Full Answer >>
  42. What are the best ways to pay off my mortgage quickly?

    There are two main strategies for paying off a mortgage more quickly, which can be used alone or in tandem: making larger ... Read Full Answer >>
  43. How do I calculate compound interest using Excel?

    In simple terms, compound interest is interest on interest. It is the interest that accumulates on the principal deposit. ... Read Full Answer >>
  44. What are the pros and cons of a simple-interest mortgage?

    The basic disadvantage of a simple interest mortgage lies in the fact that unless the borrower conscientiously makes all ... Read Full Answer >>
  45. How do interest rates coordinate savings and investment in the economy?

    In modern economies, some individuals earn more money than they need to spend on present goods. There are other individuals ... Read Full Answer >>
  46. Why should an investor consider the financial services sector?

    Any serious investor should consider the financial services sector because it offers one of the largest markets that is full ... Read Full Answer >>
  47. Why do credit card companies calculate revenue splits in terms of basis points?

    Credit card companies use basis points to calculate revenue splits because it allows them flexibility in arrangements with ... Read Full Answer >>
  48. What macroeconomic problems do policy makers most commonly face?

    Macroeconomics addresses large-scale economic factors that affect the overall population. Policymakers therefore have to ... Read Full Answer >>
  49. How does interest work on a cash advance from my credit card?

    Many credit card lenders treat interest on cash advances differently than interest on regular purchases. For starters, the interest ... Read Full Answer >>
  50. Does a cash advance hurt my credit score?

    Taking out a cash advance has no direct impact on your credit or credit score, but it can have an indirect impact in various ... Read Full Answer >>
Related Articles
  1. Economics

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  2. Economics

    How Interest Rates Affect The Housing Market

    Understand how rate changes can affect home prices, and learn how you can keep up.
  3. Investing Basics

    How Interest Rates Affect The Stock Market

    Whether you're buying lunch, a home or a stock, you're influenced by interest rates.
  4. Investing Basics

    What Investors Should Know About Interest Rates

    Understanding interest rates helps you answer the fundamental question of where to put your money.
  5. Credit & Loans

    House Price Vs. Interest Rate: Which Is More Important?

    Deciding which factor is more important can make a difference in monthly payments, ability to move and Homowners Association fees.
  6. Options & Futures

    Dividends, Interest Rates And Their Effect On Stock Options

    Learn how analyzing these variables are crucial to knowing when to exercise early.
  7. Investing Basics

    Interest Rates And Your Bond Investments

    By understanding the factors that influence interest rates, you can learn to anticipate their movement and profit from it.
  8. Home & Auto

    Lending From A Loan Officer's Perspective

    Learn how a loan officer thinks, so that you can get the best and safest loan.
  9. Savings

    Explaining Term Deposits

    A term deposit (more often called a certificate of deposit or CD) is a deposit account that is made for a specific period of time.
  10. Economics

    What is a Resident Alien?

    A resident alien is a foreigner who is a permanent resident of the country in which he or she resides but does not have citizenship.

You May Also Like

Hot Definitions
  1. Social Security

    A United States federal program of social insurance and benefits developed in 1935. The Social Security program's benefits ...
  2. American Dream

    The belief that anyone, regardless of where they were born or what class they were born into, can attain their own version ...
  3. Multicurrency Note Facility

    A credit facility that finances short- to medium-term Euro notes. Multicurrency note facilities are denominated in many currencies. ...
  4. National Currency

    The currency or legal tender issued by a nation's central bank or monetary authority. The national currency of a nation is ...
  5. Treasury Yield

    The return on investment, expressed as a percentage, on the debt obligations of the U.S. government. Treasuries are considered ...
  6. Bund

    A bond issued by Germany's federal government, or the German word for "bond." Bunds are the German equivalent of U.S. Treasury ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!