interest rate

Banking Terms -> interest rate

• The term interest rate refers to the rate at which financial institutions charge borrowers interest for using the money they have borrowed. Companies and individuals can borrow money from banks to buy new assets or goods. In return, creditors receive interest, which is calculated at a predetermined rate. Crediting institutions charge interest for not using or investing the funds in some other ways and lending them to borrowers. Interest rates are typically presented in the form of percentages within a period of 1 year. Interest rates’ projections are also used as an important tool when it comes to monetary policy. They are taken into consideration while dealing with unemployment, inflation, investments, and other variables.
  
  There are various reasons for the fluctuation of interest rates. Many times, interest rates changes due to Federal Reserve Board policies or inflation. Other reasons include risk of investment, choice of alternative investments, deferred consumption of goods, liquidity of resources, inflationary expectations, and others. With alternative investments, for example, creditors can choose to invest funds in one investment, thus forgoing the returns from a different one. Alternative investments generally compete for financing. Risk of investment is another factor. Creditors always face the risk of borrowers going bankrupt, dying, absconding, and generally defaulting on their financial obligations. For these reasons, creditors charge a risk premium to make sure that there will be compensation in case of default.
  
  Generally, interest is paid or charged for using money. It is oftentimes expressed in the form of an annual percentage of the principal amount. The interest rate is computed by dividing the interest amount by the principal amount. For instance, if a creditor charges clients $80 a year on a loan of $1,200, the interest rate is computed as follows: 80/1200 x 100 = 6.66 percent. From a consumer’s point of view, interest rates are expressed in the form of APY (annual percentage yield). When borrowers pay interest on a loan, mortgage, or a credit card, then the interest rate is referred to as annual percentage rate.
  
  The assets borrowed are generally consumer goods, cash, and large assets, including buildings and vehicles. Interest represents a leasing charge for the use of assets. Regarding large assets such as real estates and vehicles, the interest rate is also referred to as lease rate.
  
  As a general rule, financial institutions will charge a lower interest rate if the borrower is considered low risk. Borrowers with a tarnished credit score are normally considered risky and charged higher interest rates.
  
  Creditors charge interest because they forgo other investment opportunities. There are two types of interest, simple interest and compound interest. The first type is calculated with the help of the simple interest rate formula. Basically, simple interest is found by multiplying the annual interest rate by the principal and the number of years. Simple interest is computed only on the original principal. Accumulated interest is not taken into account in calculating the interest rate for future periods. In addition, banks use simple interest over a single period, which is shorter than one year (it can be used, for example, over a period of 30 to 60 days). Compound interest is computed on interest accumulated over all past periods, plus the original principal. Thus, compound interest is computed every period. The compounding periods can be quarterly, yearly, continuously, etc. Compound interest can be viewed as a series of contracts with simple interest. The interest that is earned over every period is added to the principal amount from the last period and becomes the principal over the next one. Compound interest is preferred by financial institutions, and clients benefit more from it in the long run.

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