Understanding Interest Rate and Examples

Interest Rates

Understanding Interest Rates

When you borrow money, there are several reasons why lenders don't want to give it away for free. One reason is that the same amount today may lose value in the future, because prices tend to rise due to inflation.

The lender can get a refund by investing it if he doesn't lend it to you. And she runs the risk that maybe you won't return it. To make up for this loss, the lender usually charges interest - This interest is the cost of borrowing money. You can earn interest by putting your money in things like a savings account or a certificate of deposit (CD), you can also pay interest on student loans, mortgages, or credit card balances.


Suppose you borrow $ 200 for one year at 3% interest. This means that you will pay back the $ 200 you borrowed at the beginning (known as principal) as well as the $ 6 in interest at the end of the period. If your friend applies for a loan with the same amount from the same institution but gets an interest rate of 10%. At the end of the period (one year), he will pay $ 200 along with $ 20 in interest.

The same loan can arise with different interest rates depending on the market rate and how risky the lender is assessing the borrower. This is an example of a small number, but with a larger loan amount and a longer period of time, interest can make a big difference!


Just like in the preschool days, people don't always like to share…

Especially, if there is no guarantee they will get their goods back. Interest rates give creditors the confidence they need to part with their money temporarily and bear all the risks involved.

What Are Interest Rates?

The interest rate is the cost of borrowing money, usually expressed as a percentage. Interest rates fluctuate from time to time, and the specific rates you may earn or pay are determined by a variety of factors. One important consideration is the current interest rate, which is influenced by the interest rate of the Federal Reserve, the US nation's central bank which charges other banks for borrowing money. The Federal Reserve is typically reactive to the economic and interest rate environment.

The Federal Reserve often cuts interest rates to spur economic growth and prevent unemployment, then raises them again when the economy is doing well. In determining the individual rate, your lender will also consider how risky you are as a borrower. It involves things like your credit history, the level of your debt compared to your income, and negative financial issues in your past, such as bankruptcy.

Interest rates can be calculated in different ways, but the goal is always the same - To make the lender feel comfortable lending you money given the opportunity cost and the risks involved.

How Do Interest Rates Work?

The amount of interest you pay (or earn, if you are a lender) depends on four factors:

  1. The amount of money borrowed
  2. How long has the money been borrowed (duration of the loan)
  3. How often interest is calculated (daily, monthly, yearly, etc.)
  4. Interest rate

All things being equal, the more you borrow, the more you will pay interest, because interest is calculated as a percentage of the loan amount. In general, the loan amount will also get bigger the longer you borrow, because it takes more time to accumulate interest.

The frequency of calculating interest also affects the total amount you owe. We'll get into the details below, but basically, the more often the interest is calculated, the higher the final amount. So a 3% calculated on a monthly basis will generate more interest than the 3% interest calculated annually, even if the initial loan amount and loan term are the same.

The higher the interest rate, the more interest you will pay - a 10% interest will earn you more interest than a 5% interest rate, if the other factors are the same. The conclusion is that when you compare interest rates, you have to make sure that you are comparing apples to apples (having the same factors). As we just discussed, the interest of 3% per month is different from 3% annually.

APR (Annual Percentage Rate) is the most common interest formula used in consumer financing. Expressed as a percentage, these are the likely numbers you'll see when you take out a credit card, car loan, or mortgage. The APR includes not only interest, but usually other costs associated with the loan, per year. So, if on payday the lender adds a $ 10 setup fee, it may be included in the APR.

APY (Annual Percentage Yield) is also expressed annually, but unlike APR, APY is also related to the factor of how often interest is calculated. So if your interest rate is 3% per year, without any additional fees, your APY is 3%. If your interest rate is calculated as 3% every month, then your APY is actually 3.04%. (The formula for APY is (1 + r / n) n - 1 where r is the interest rate and n is how often the interest is calculated).

What is the Difference between Simple Interest Rate and Compound Interest Rate?

Usually you find out how much interest you have in a given period by multiplying the interest rate by the amount you borrow. But is the principal amount of your loan or loan today, now the interest has accumulated? So that's the difference between simple interest and compound interest.

Calculating simple interest simply means multiplying the interest rate by the principal on the loan (or the initial amount borrowed). Compound interest means multiplying the interest rate by the principal plus any unpaid interest. That is why the more often interest is calculated, or combined, the more interest will be paid or earned in total.

Imagine borrowing $ 100 for 12 months at an interest rate of 12% per annum. If you are dealing with simple interest, the interest you have at the end of the year is 0.12 *

$ 100 = $ 12. SO IN TOTAL YOU WILL PAY $ 100 + 12 = $ 112.

Now suppose 12% is compound interest, and compound interest monthly. This means that at the end of each month interest will be calculated based on the amount that has not been paid at that time ($ 100 plus any interest). After one month, you owe about $ 101 ($ 100 x (12% per year divided by 12 months)). In the second month you have to pay $ 101, not $ 100. After the third month you have to pay $ 102 in interest, and so on. (for details, the figures are rounded to the nearest dollar).

How to Calculate Interest Rates?

To find out how much interest you will pay, you need to pay attention to four things, as we discussed earlier:

  1. Loan principal or amount borrowed (P)
  2. Loan duration (t)
  3. How often is interest calculated (n)
  4. Interest rate (i)

To help us calculate the most common flowers, let's follow a scenario:

You took out a $ 1,000 (P) loan for two years (t) at an interest rate of 5% (i). If there is no combination, you can use a simple interest formula, namely:

P (1 + rt)

$ 1,000 (1+ (.05) (2)) = $ 1,100

So, at the end of two years you owe $ 1,100 - that's $ 1,000 of principal plus $ 100 in interest.

Now imagine a compound interest of 5% each month. The formula for calculating compound interest is:

P (1 + i / n) ^ nt

$ 1000 (1 + .05 / 12) ^ (12 * 2) = $ 1,104.94

Note: you can also use this calculation if there are no concatenations - just  enter '1 n as n.

What are Good Interest Rates Like?

There is no definite definition of a "good" interest rate. In general, lenders want the highest possible interest rates, while borrowers want the lowest. The amount you can earn depends on several factors, including your creditworthiness and market price.

If you are offering an interest rate, how do you know if it is good? A great place to start is checking market rates averages. For example, using Bankrate.com, you can find the current rates on various products. As of October 2019, here are some average rates:

30 year fixed mortgage rate: 3.96%

15 year fixed mortgage rate: 3.26%

60 months new car loan interest rate: 4.61% 48 month new car loan interest rate: 4.57% variable credit card rate: 17.56% student loan: 2.14% - 5.74%

If you are offering a rate above the current market average, you can be sure that it is a good rate.

One of the worst interest rates you can get, as a borrower, is on short-term emergency products, such as pay-out loans and down-payment loans. The Federal Trade Commission warns people who often have an APR as high as 391%!

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