Interest rates are often expressed as a percentage of the principal amount of a loan and are commonly calculated annually. There are two types of interest rates - simple interest and compound interest, and understanding both, as well as their differences, is very important.
Not just that, there are many other classifications of interest rates, which are again very important to understand.
Learn the difference between the two terms in this article, and you'll be on your way to determining your own interest rates!
Did You Know?
The levels of the Interest rate are supply factors and credit demands. For example, if there’s an increment in the demand for cash/credit, then the interest rate will be raised. However, a decrease in the demand for credit might decrease them.
Also Read: Simple Interest Calculator
What is Interest Meaning?
In finance, interest meaning is the cost of using someone else's money. You pay interest when you borrow money from a bank or credit card company, and you can earn interest by placing your money in an interest-bearing account.
Interest-bearing accounts include savings accounts and certificates of deposit. This way, you can earn money while not using the money. The type of interest varies, too. The most common type is compound interest, which means paying interest on your borrowed money. This type of interest is the most common today, and it's widely accepted.
Whether you want a loan with a low-interest rate or one with a high rate, you can find the right loan for you. So, what does interest mean in finance? It's the cost of borrowing money divided by the amount you lent. Now that you know what is the interest rate. Let's learn some of its types.
What Is Compound Interest?
Compound interest meaning is especially valuable for borrowers as it allows you to earn increasingly larger amounts of money off your initial investment. The best way to understand this type of interest is to know how it works in a savings account. Generally, you can use compound interest to calculate your savings or investments.
This is a process that takes many steps. You must first calculate the compounding period. Typically, you use 12 months per compounding period. In other words, if you invested ₹100 a year, you would earn an additional ₹500 every year, and that amount would add up to ₹1500 after five years. However, you can also use a daily compounding period (360 or 365).
Using the Rule of 72, you can estimate how long it will take to double your account's value. If you deposit ₹1,000 a year, it will be worth ₹2,000 in twenty years. Divide 72 by 20 to get the APY, or Annual Percentage Yield, of 3.6%. By using the Rule of 72, compounding works in your favour and allows you to save money individually. This is a useful tool when it comes to building savings.
What Is Simple Interest?
Despite the seemingly complicated math involved, a simple understanding of interest can help you make smart financial decisions. Here are some examples:
The basic interest definition is the money you pay for borrowing money. In real life, interest is calculated using more complicated methods. Other costs not included in the interest rate may also affect the loan amount.
Knowing simple interest meaning can better target your debt repayment strategy and maximise your finances. You can use the calculator to compute simple interest rates for deposits and loans. Put P=principal and R=interest rate. Then, enter the number of periods you wish to calculate the interest. When you enter the value of r, make sure it is in decimal form.
Otherwise, it will be rounded down to the nearest whole number. This will make it easier to calculate the interest. You can also calculate interest using other interest calculations by using the simple interest equation.
Difference Between Simple and Compound Interest
Understanding the difference between simple and compound interest rates is important for anyone who wants to find the best savings account and loan. While it may be tempting to choose the easiest option, it is not the best option for many.
A borrower doesn't want to be saddled with debt that could take years to pay off. Meanwhile, investors would like to accumulate money that they can use for retirement. In either case, searching for a savings account with frequent compounding is essential.
Simple interest is the amount you pay on a loan, while compound interest accrues interest on the principal. Simple interest is easier to understand and calculate because the loan principal is a fixed amount.
On the other hand, compound interest is calculated based on the accumulated interest of previous periods. It is usually owed on mortgages, personal loans and car loans, and it is possible to earn higher returns by combining these types of loans.
Also Read: What is the Definition of Financial Accounting and What Does it Deal With?
What Are the Different Types of Interest Rates?
There are three main types of interest rates - nominal, effective and real. First, let us know what is interest rate on each type and then, you can compare each type to make an informed decision about the best interest rate for your situation.
The differences between nominal and effective rates are significant in the context of lending. Nominal interest rates are often lower than real ones, usually used on credit cards. In contrast, variable interest rates are dependent on current market interest rates and are most often used on loans, mortgages and credit cards. Keep reading to know more:
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Real Interest
Often, the real interest rate is a useful metric for understanding the state of the economy. It explains different economic phenomena such as capital flight, business cycles and economic bubbles. A high real interest rate indicates that the borrowers are willing to pay more for the borrowed funds. On the other hand, a low real interest rate implies that borrowers are willing to spend more on physical investments.
However, the rate at which real interest rates rise and fall is largely determined by the level of inflation. To understand how the real interest rate works, we must first understand how interest rates affect the economy. The Federal Reserve uses the real interest rate as the North Star of its monetary policy.
When the Federal Reserve dropped its fund's rate to zero after the financial crisis, it believed that companies would borrow more money at rock-bottom interest rates and investors would pour cash into the stock market. This low-interest rate "accommodated" riskier behaviour, and investors bought stocks for a decade.
Since the 1980s, real interest rates in most countries have declined. The long-run average of real interest rates globally has converged internationally over the past quarter-century.
This pattern is consistent with an increasingly interconnected world. Furthermore, real interest rates were already trending downward long before the global financial crisis and the IT boom. However, the Great Recession has heightened the chances of nominal interest rates reaching the zero lower bound.
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Nominal Interest
Nominal interest rates are like the sticker price of a new computer, and they reflect the market's mood but are not a true representation of the actual returns from the market. Nominal rates are often higher when things are going well and lower when the economy suffers. Ultimately, the interest rates set by the central bank will determine the actual returns you can expect to see in the market.
One way to calculate nominal interest rates is by looking at the expected inflation rate. For example, a 15-year mortgage with a nominal interest rate of 6% would have a real interest rate of 3%, as inflation has increased by 3% in that time. For this example, a real interest rate of 1% would benefit the borrower, lender and bank. If inflation were negative 1%, the lender would make a profit.
Negative nominal interest rates can reflect recessionary or safe haven conditions. In the 1970s, Switzerland had negative nominal interest rates for short-term deposits because its central bank wanted to discourage flight to quality by limiting the value of the Swiss franc.
The franc's depreciation harmed the country's economy, but the central bank still intended to stimulate the local economy by encouraging investors to buy safe government bonds. In 2009, Sweden briefly experienced negative nominal interest rates for short-term deposits.
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Effective Interest
The difference between the stated interest rate and the effective interest rate is the effective annual or periodic interest rate. An effective interest rate is the interest rate over a specific period divided by the number of compounding periods.
The effective annual interest rate is computed through a formula. The interest rate is represented as the stated amount, compounding intervals as the number of times the loan will be paid, and "r" as the compounding interval.
The effective annual interest rate will display the actual rate of interest that the borrower is receiving on the investment. Also, the effective annual interest rate helps students stay ahead of their competition by providing a true comparison of the interest rates they are being charged on their loans.
The effective annual interest rate, or EAAR, is the real return of an interest-paying investment or savings account. It is calculated by taking the effects of compounding into account.
A higher EAAR will mean higher interest payments. Effective interest rates also differ from annual percentage rates based on simple interest, making them essential marketing tools for financial institutions. These terms also describe the interest rate charged on credit card debt.
Conclusion
The interest rates apply to the majority of loans and borrowing activities. People take out loans to purchase houses, fund projects, launch businesses or pay college tuition. Businesses borrow loans to finance capital projects and expand their business by buying durable and fixed assets like land, buildings and equipment. So, understanding various types of interest rates is compulsory for both lenders and borrowers.
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