What is an Interest Rate?

Interest rate can be seen as a percentage of an initial amount borrowed by an entity that is charged to the borrower from the loaner/lender of said money. The APR or annual percentage rate is the term used to describe an interest rate on a loan that is recorded annually. Interest rates are similarly applied to sums earned by financial institutions from a CD (Certificate of Deposit) or a savings account. The income generated on these accounts is denoted by the annual percentage yield (APY).

Understanding Interest Rates

So what is Interest rate? Well, it is simply fee levied against the borrower for things like taking out money, using basic commodities, using vehicles, using consumer goods, and loans in the real estate market. Common reasons for borrowing money include purchasing a home, investing in infrastructure, establishing or expanding a business, or paying for tuition, and it is important to realize that all of these sorts of loans, as well as many others, are subject to interest rates. Similarly, companies and corporations also use loans to support their endeavours, investment projects, and to grow their business by acquiring fixed assets such as real estate, offices, innovative technology, and machinery.

Note that borrowed funds are repaid in either a bulk amount or in periodic instalments by a predetermined date. For example, interest rates for bonds are determined before the bond is instated and is listed on the terms and conditions. In the case of loans, interest rate is used on the principal, but, a borrower’s debt cost and the lender’s amount of return can also be seen as interest rate.

Since lenders seek reimbursement for the loss of use of the money loaned during the lending time, the amount to be returned is frequently above the initial loan amount. Essentially, instead of making a loan, the lender should have spent the money elsewhere over that period, creating income from another source whatever that may have been. Note that the interest charged is the final payback amount subtract the original loan amount.

It is vital to have an excellent credit score since you will need one if you want to qualify for the best loans, as risk is frequently taken into account when a lender checks said credit score.

Essentially, when a lender deems someone low risk, said person will pay a reduced interest rate and, in turn, if an individual is deemed high risk, the person will pay their interest rate at a premium, resulting in a more expensive loan.

Interest Rate Example

Let’s say you obtain a $1 million mortgage from a lender to buy a home, the loan specifies an 8 percent interest rate that will be paid back in 1 year, you will be required to payback the initial principal of $1 million + 8 percent x $1,000,000 x 1 Fiscal Year, to the bank. Therefore, the final amount will be $1 million + $80,000 = $1,080,000.

Simple Interest Rate

Simple Interest Rate Formula:
(Principal)*(interest rate expressed as a percent)*(time expressed in years)

To give one a better perception of how banks and lenders indeed make money from interest rates consider the example above which had an interest rate equal to 8% which equates to a payment of $80,000 in interest per year meaning that the individual who borrowed the money would pay $80,000 x 10 years amounting to $800,000 in payments after 10 years has passed.

Compound Interest Rate

Fundamentally, the bank assumes that the individual who borrowed the money owes the principal and the interest for the first year. Then, the bank also anticipates that when the second year ends, the investor must pay the principal, the 1st year’s interest, and the interest on the interest paid for the 1st year. However, lenders frequently prefer compound interest over simple interest since compound typically results in the borrower paying more interest. Because compound interest is applied to both the principal and already accumulated interest from previous periods, it is usually referred to as the interest of interest.

Confusing, yes, but imagine it like this, say you pay $100 interest on a loan for one year, you must pay the interest for the first year when it ends, and then in the second year assuming the interest rate is 5% you must pay 5% of the $100 in interest you paid last year.

When using compound interest the interest calculated is greater than interest that is calculated when utilizing simple interest. Note that monthly interest is applied to initial loan amount plus the accumulated interest from prior months. Whereas, for shorter periods, the interest calculation will be close for both compound and simple. Fundamentally, when the lending period increases, the difference amid both compound and simple interest calculations increases.

Compound Interest Formula:

(Principal)*[(1 + (the interest rate) ^ (# of compounded periods) – 1]

Compound Interest & Savings Accounts

Compound interest is beneficial when saving money with savings accounts. Essentially, the interest received gets compounded, then paid to the owner of said account as reimbursement for allowing a given financial institution to access the funds in said savings account. Let’s put it this way if you put $1 million in a savings account with a high-yield, and your bank takes $600,000 of that amount to use for a loan. Subsequently, the bank will compensate you by depositing 2% interest into your account each year. Essentially, even though the bank takes 6%, it gives 2% to the lender, resulting in a 4% interest yield. All in all, saving money and giving it to the bank, lends money to people in exchange for interest for both you and the bank.

Borrower's Cost of Debt

Interest rates indicate the borrower’s cost of debt as well as revenue for lenders. Businesses often compare the borrowing cost vs. equity cost, to decide what type of funding is the most cost-effective. This is due to the fact most businesses raise funds by accumulating debt or issuing stock, meaning that the capital cost is calculated to establish the best capital structure.

APR vs. APY

Consumer loan interest rates are often expressed as an APR or annual percentage rate. APR is the return rate required by lenders in return for the privilege to lend money. Interest rates on bank cards, for example, is expressed as APR. One should note that APR fails take in account compound interest for the year.

Now that we’ve covered APR, let’s look into APY, also known as annual percentage yield. APY is essentially an interest rate generated on a savings account or certificate of deposit at a bank or other financial institution. It should also be noted that, unlike APR, APY takes into account compounding interest.

How Are Interest Rates Determined?

Bank interest rates are governed by a variety of factors, including current economic state. The interest rate determined by the central bank of a country, for example, the Federal Reserve is used by every financial institution in the U.S in order to define its APR range that it can offer. Normally the range that is offered in the U.S is around 13.99% to 23.99%, although, it can vary depending on certain factors. Whenever a central bank raises interest inflation increases, as well at the cost to borrow. Moreover, if the borrowing cost is high, both businesses and consumers are discouraged from borrowing resulting in a decline in consumer demand.

To lighten the effect of said inflation many financial institutions may impose stricter reserve requirements to narrow the supply of money or increase credit demand. Furthermore, when interest rates are quite high in the economy, the savings rate is significantly greater than normal as most people prefer to save money than spend it. This, in turn, greatly affects the market because people want to utilize of higher savings rates rather than invest in a faltering stock market. As a result, companies and fellow investors see decreased profits. Moreover, businesses have made capital funding via debt nearly impossible to execute, which contributes to an economic downturn.

Since borrowers may get loans at low-interest rates, economies are frequently stimulated during said periods with low interest rates. Although one should note when savings interest rates are low, most individuals are more willing to invest in risky investments and spend their money. This increase in spending stimulates the economy and injects capital into the markets, resulting in economic growth. While governments want low interest rates, ultimately they cause market instability in which demand ends up being greater than supply, resulting in inflation that subsequently leads to rising interest rates. This theory can be identified as Walras’ law, which is an economic theory that states that when there is excess supply in one market it must be greeted by excess demand in another market so that balance is created in both market.

Interest Rate & Discrimination

Despite legislations like the Equal Credit Opportunity Act, which forbids prejudiced lending practices, institutional racism exists in the United States and several other nations. A plethora of studies conducted in the United States shows that people in mostly Black neighbourhood’s people are given mortgages that have higher interest rates than buyers in mostly White neighbourhoods. In other research, discriminatory interest rates add on average $10,000 to the cost of a 30-year fixed-rate home loan.

The Consumer Financial Protection Bureau that enforces the Equal Credit Opportunity Act, released a Request for Information in summer 2020, requesting the public opinion to identify ways to enhance the Equal Credit Opportunity Act and how it assures non-discriminatory access to loans.