Interest Rate

Reviewed by Annapoorna | Updated on Aug 27, 2020

What is Meant by Interest Rate?

Interest rate refers to the amount a borrower must pay to the lender for the usage of assets and is usually denoted as a percentage of the amount of principal. The interest rate is generally calculated on an annual basis known as the annual percentage rate. The assets obtained on hire could include consumer goods, cash, or significant assets such as a vehicle or building.

Interest is actually a rental or leasing charge to the borrower for the asset used. For a large asset such as a vehicle or building, the lease rate may substitute as the interest rate. When the borrower is having a low risk as assessed by the lender, he will normally be charged a lower interest rate. If the borrower is said to have a high risk, the interest rate charged may be higher.

The interest rate is calculated on the principal, which is the amount of the loan. The interest rate is the price of debt for the borrower and the rate of return for the lender. Most mortgages apply simple interest. But some loans also use compound interest. It is applied to the principal and also to the interest accumulated for the previous periods.

The annual percentage rate is the interest rate which is earned at a bank from a savings account or certificate of deposit (CoD) which use compounded interest.

Application of Interest Rate

Interest rates apply to most of the borrowing transactions. Individuals borrow money to buy homes, fund and launch ventures, fund businesses or pay for college tuition. Businesses obtain loans to fund capital projects and grow their operations by acquiring fixed and long-term assets such as land, buildings, and machinery. Borrowed money is repaid either at once by a pre-determined date or in periodic instalments.

The money for repayment is generally more than the borrowed amount because lenders need compensation for the loss of value of the money for the loan period. The lender could have invested the funds on an asset during that period and not provided a loan for generating income from the asset.

Types of Interest Rate

Interest charged is the difference between the repayment sum and the original loan disbursed, and its types are listed below.

Simple Interest:

Consider that an individual takes out a Rs 500,000 mortgage from the bank and the loan agreement lays down a condition that the interest rate on loan is 12%. It means that the borrower will have to repay the bank the original loan amount of Rs 500,000 + (12% x Rs 500,000) = Rs 500,000+ Rs 60,000 = Rs 560,000. It is referred to as the simple interest calculation.

Compound Interest:

A borrower pays even more in interest under compound interest calculation. Compound interest is also called as the interest on interest. It is applied to not only the principal but also on the accumulated interest of past periods.

The bank estimates that at the end of the first year that the borrower owes the principal plus interest for that year. The bank also estimates after the second year that the borrower owes the principal plus certain interest. The interest includes first-year interest, second-year interest, and the interest on interest for the first year.