Interest rates: what are they, purposes and main types

Sushree Behera

29 April 2023

Do you ever wonder why financial transactions such as loans, credit cards, and bank deposits involve the term ‘interest’? What is interest rate? Does it really matter to you when it comes to managing your finances?

Interest rates are an important part of a financial system. Understanding the different types of interest rates can help you make better financial decisions. In this article, we will discuss the different types of interest rates and how they are determined.

Table of Contents

What are interest rates, and why should you be concerned about them

Interest rate is the percentage of an amount loaned or borrowed that needs to be paid as an additional charge. Lenders frequently represent it as a percentage of the loan’s total principle or sum of all loans made. Interest rates play an essential role in our economy, and they affect different sectors, including consumers, businesses, and the government.

As someone who borrows money, you should be aware of interest rates since it can add to your debt burden. Thus, it is extremely important for you to understand different interest rates available in the financial market. This will help you make better informed financial decisions.

Different types of interest rates

Let’s explore the 2 most common types of interest rates which you must be aware of.

1. Simple interest

Simple interest is one of the most common methods which lenders and borrowers use to calculate the cost of a loan. It’s easy, straightforward, and perfect for smaller loans or those with short-term repayment periods.

Simply put, simple interest is calculated as a percentage of the amount borrowed. This percentage is applied to the principal amount each month or year, depending on the terms of the loan. For example, if a borrower takes out a loan with an interest rate of 5%, and the repayment period is one year, they’ll have to pay interest at 5% per annum (1/12th of 5% per month).

Simple interest is easy to calculate and understand, making it a popular choice for borrowers who are new to loans. It’s also more beneficial as the interest remains fixed throughout the loan period, so you know exactly what you’re going to owe each month. Finally, the interest rate won’t increase if you pay your loan early early.

The biggest disadvantage of simple interest is that it doesn’t take into account how quickly you repay the loan. This can be a problem if you don’t have much money to start with, as even small repayments could add up to a large interest rate over time. Additionally, the borrower is in charge of keeping track of their loan payments. Thus, borrowers need to ensure that they make the loan payments on time each month.

2. Compound interest

One of the most crucial ideas to comprehend when it comes to borrowing, investing, and saving is compound interest rate. It adds interest on top of interest, which can make a significant difference over time.

Compound interest, often known as interest on interest, is simply the addition of interest to the principal amount of a loan or deposit. Check the following equation:

Interest = principal x (1 + rate of intrest)^periods

There are two types of compound interest rates:

Simple Compound Interest Rate: In this type of compound interest, the formula for calculating it takes into account only the principal and rate of interest. The best-suited type of interest rate for short-term investments or loans.

For example, if you borrow a loan from a bank of $1000 at a 5% simple compound interest rate, then after one year, you’ll have to pay the bank $1050 for that loan – principal + interest (5% of principal).

Compound Interest Rate with Continuous Compounding: This type of compound interest rate usually applies to long-term investments or loans, and the formula used to calculate it takes into account the principal and rate of interest earned in past periods.

For example, if you borrow a loan from a bank of $1000 at a 5% continuous compound interest rate, then after one year, you’ll have to pay back more than $1050 for that loan – i.e. (1+5%)^1 * 1000.

Compound interest can be calculated on interest earned in previous periods. On the contrary, it can be difficult to calculate sometimes. Moreover, it’s often used for long-term investments or loans.

How are your interest rates determined?

Interest rates are the amount of money you pay to borrow money. Lenders determine your interest rate, which is a key factor in determining how much you’ll end up paying for a loan, so it’s important that borrowers understand how lenders determine their rate.

Lenders decide on an interest rate based on a number of factors. One of the most important factors is your credit score because it shows how creditworthy you are. If you have a higher credit score, lenders are likely to offer you a lower interest rate because they can be confident that you’re more likely to pay your loan back in full and on time.

Not just this, your income also plays a crucial role in determining your interest rate. Lenders aim to provide loans that are feasible for their customers. In doing so, the interest rates they offer will vary based on the income of the borrower. Typically, borrowers with a higher income will receive a lower interest rate. This strategy helps to ensure that loan payments are more manageable for customers.

Your other debts and liabilities also play an important role in determining your interest rate. If you have a lot of other debts, lenders may be less likely to offer you a lower rate because they may view it as riskier to lend money to someone with a higher debt burden.

The type of loan you’re applying for will also affect your interest rate. For example, if you’re getting an auto loan, lenders may offer you a lower rate because they know that the vehicle will serve as collateral.

Finally, the market conditions and the loan terms can also determine your interest rate. If lenders are competing for business, they may be willing to offer more competitive rates in order to attract borrowers. And if you’re getting a longer-term loan, you may have to pay a higher interest rate than if you’re getting a shorter-term loan.

To make an informed choice while choosing the best loan and lender for your circumstances, be aware of how the lender calculates your interest rate. This way, you’ll be able to control the cost of borrowing money. Moreover, you will also have a better understanding of how creditors assess your creditworthiness.