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, and large assets such as a vehicle or building.


Interest Rates: Nominal and Real


Interest is essentially a rental, or leasing charge to the borrower, for the use of an asset. 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, s/he 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.

In terms of borrowed money, the interest rate is typically applied to the principal, which is the amount of money lent. The interest rate is the cost of debt for the borrower and the rate of return for the lender.

Interest rates are applied in numerous situations where lending and borrowing is concerned. Individuals borrow money to purchase homes, fund projects, start businesses, pay college tuition, etc. Businesses take loans to fund capital projects and expand their operations by purchasing fixed and long-term assets such as land, buildings, machinery, trucks, etc. The money that is lent has to be repaid either in lump sum at some pre-determined date or in monthly installments, which is usually the case. The money to be repaid is usually more than the borrowed amount since lenders want to be compensated for their loss of use of the money during the period that the funds are loaned out; 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. The difference between the total repayment sum and the original loan is the interest charged. The interest charged is an interest rate that is applied on the principal amount.

For example, if an individual takes out a $300,000 mortgage from the bank and the loan agreement stipulates that the interest rate on the loan is 15%, this means that the borrower will have to pay the bank the original loan amount of $300,000 + (15% x $300,000) = $300,000 + $45,000 = $345,000. If a company secures a $1.5 million loan from a lending institution that charges it 12%, the company must repay the principal $1.5 million + (12% x $1.5 million) = $1.5 million + $180,000 = $1.68 million.

Simple Interest Rate

The examples presented above are calculated based on the annual simple interest formula, which is:

Simple Interest = Principal x Interest Rate x Time

The individual that took out a mortgage will have to pay $45,000 in interest at the end of the year, assuming it was only a one-year lending agreement. If the term of the loan was for 20 years, the interest payment will be:

Simple Interest = $300,000 x 15% x 20 = $900,000

An annual interest rate of 15% translates into an annual interest payment of $45,000. This means that after 20 years, the borrower would have made $45,000 x 20yrs = $900,000 interest payments. Now you get a sense of how banks make their money.

Compound Interest Rate

But banks almost never charge simple interest. They prefer the compound interest method which means that the borrower pays even more in interest. Compound interest, also called interest on interest, is interest rate that is not only applied on the principal, but also on accumulated interest of previous periods. The bank assumes that at the end of the first year, the borrower owes it the principal plus interest for that year. The bank also assumes that at the end of second year, the borrower owes it the principal plus the interest for the first year plus the interest on interest for the first year.

The interest owed when compounding is taken into consideration is higher than that of the simple interest method, because interest has been charged monthly on the principal including 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.

Following our mortgage example above, the table below is an illustration of how compound interest works.

Table demonstrating compound interest as it relates to a mortgage

At the end of 20 years, the interest owed will be almost $5 million on a $300,000 loan. A simpler method of calculating compound interest by using the formula:

Compound Interest = Principal x [(1 + interest rate)n – 1], where n is the number of compounding periods.

When an entity saves money using a savings account, compound interest is favorable. Interest that is earned on these accounts are compounded and is compensation to the account holder for allowing the bank use the funds deposited. If a business deposits $500,000 into a high-yield savings account, the bank can take $300,000 of these funds to loan the mortgagor in the example above. To compensate the business, the bank pays 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, that is, the bank’s lender, netting it 9% in interest. In effect, savers lend the bank money which, in turn, lends borrowers the money in return for interest.

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Interest rates on consumer loans are typically quoted as Annual Percentage Rate (APR). This is the rate of return that lenders demand for borrowing their money. Example, the interest rate on credit cards is quoted as an APR. In our example above, 15% is the APR to the mortgagor. The APR does not take compounding on interest for the year into account.

The Annual Percentage Yield (APY) is the interest rate that is earned at a bank or credit union from a savings account or certificate of deposit (CD). This interest rate takes compounding into account, and thus, tells the consumer or business what it is really earning by saving money.

Cost of Debt

While interest rates represent interest income to the lender, it constitute a cost of debt to the individual and business. Companies weigh the cost of borrowing against the cost of equity, such as dividend payments, to determine which source of funding will be the least expensive. Since most companies fund their capital from either taking on debt and/or issuing equity, the cost of the capital is evaluated in order to achieve an optimal capital structure.

Interest Rate Drivers

The interest rate charged by banks is determined by a number of factors, including the state of the economy. The interest rate in the economy is set by a country’s central bank. When the central bank sets interest rates at a high level, the cost of debt rises, discouraging people from borrowing and slowing consumer demand. Furthermore, interest rates tend to rise when – inflation goes up, higher reserve requirements for banks are set, tight money supply ensues, or there is greater demand for credit. In a high interest rate economy, people resort to saving their money since they receive more from the savings rate. The stock market tends to suffer as well since investors would rather take advantage of the higher rate from savings than the lower returns from the stock market. Businesses also have limited access to capital funding through debt, which leads to a contraction in the economy.

During periods of low interest rates, the economy is stimulated as borrowers have access to loans at inexpensive rates. Since interest rates on savings are low, businesses and individuals are more likely to spend more and purchase riskier investment vehicles, such as stocks. This fuels spending in the economy and capital markets, leading to an economy expansion. While a government will prefer interest rates to be low, low interest rates eventually lead to a market disequilibrium in which demand rises higher than supply, causing inflation. When inflation arises, interest rates increase.