Interest rates

What are the types of interest? | Interest rate

No matter which side of a financial transaction you are on, it’s important to understand the concept of interest. These are the fees charged for borrowing money, often a percentage of the amount borrowed. For lenders, this is what they can expect to get out of the deal. For borrowers, this is the cost of this transaction.

While the concept of interest remains the same, it takes on different forms. The type of interest you are dealing with depends on the nature of the investment, the amount, the duration and the people involved in the transaction. In total, there are seven main types of interest.

1. Simple interest

This is the rate charged by banks for borrowing money. It is calculated by multiplying the daily interest rate by the principal and then by the number of days between payments. Simple interest does not consist of. The equation looks like this:

A = P (1 + rt)

  • A is the final amount
  • P is the balance of the initial capital
  • r is the annual interest rate
  • t is the term

You will typically encounter straightforward interest on most personal loans, auto loans, and other short-term loan products. While it’s easy to evaluate different loans and rate options by looking at simple interest, note that it doesn’t factor in loan fees.

2. Compound interest

Every investor should be familiar with compound interest. This is, after all, what is responsible for the wealth generated by the investments. The longer the term and the longer the compounding periods, the more money paid in interest. The compound interest equation looks like this:

A = P (1 + r / n)NT

  • A is the final amount
  • P is the balance of the initial capital
  • r is the interest rate
  • m is the number of interest applied per period
  • t is the number of elapsed time periods

Compound interest takes into account the accumulated value of interest payments with each new compound event. To see exactly how powerful compound interest is, plug a few numbers into our compound interest calculator and see the feedback for yourself!

3. Fixed interest

Fixed interest does not change. This is a single interest rate tied to the initial principal balance and represents the total amount the borrower must repay over time, or how much the lender will earn. The formula looks like this:

A = P xr

  • A is the final amount
  • P is the balance of the initial capital
  • r is the interest rate

Fixed interest tends to accompany certain types of loans, but is mostly associated with bonds. Investors buy bonds knowing clearly how much they will earn on their investment based on the bond’s interest rate.

4. Variable interest

Interest rates are not always static. Variable interest rates represent a rate that has the power to change monthly or annually, depending on the product and the pricing environment. To calculate the total interest generated by a variable interest rate, you must calculate the simple interest rate for each period, taking into account the new rate for each calculation. The accumulated interest is the sum of the interest generated for each period.

Variable interest arises in different investment and loan products. Equity investments do not have the same rate of return from year to year, and variable rate mortgages (ARMs) change relative to the prime rate. Variable rates can be attractive to borrowers in favorable rate environments but cumbersome as rates rise.

5. Annual percentage rate (APR)

Most often associated with credit cards, The APR represents the total interest, expressed annually on the total cost of the loan. Credit companies formulate the APR by taking the prime rate and creating a margin. The formula for APR looks like this:

APR = (((F + I / P) / n) x 365) x 100

  • F represents the costs
  • I is the total interest paid over the term of the loan
  • P is the main balance
  • m is the number of days of the loan term

The APR is a useful tool for comparing loans; however, it can also be a misleading number. It is essential to distinguish between APR and Annual Percentage Yield (APY), which takes into account composition. As a result, the APR is not an accurate reflection of the total cost of borrowing.

6. Interest at prime rate

The prime rate is the best interest rate offered by banks for loan products. It is reserved for the most creditworthy borrowers only, and banks use it as a benchmark to raise interest rates on their financial products.

Where does the prime rate come from? It is set by central banks and the Federal Reserve. The lower the rate, the lower the consumer interest rates and the easier it is to borrow money. Likewise, the higher the prime rate, the higher the secondary and tertiary rates, which makes borrowing more difficult.

7. Discounted interest rate

The discount interest rate is a type of interest that is not geared towards the consumer. Rather, it is the rate at which central banks and the Federal Reserve use when they lend money to other financial institutions. This rate covers short-term borrowing primarily used to help correct liquidity and cover funding shortages. The rate is extremely low so as not to hamper the borrowing institution.

Familiarize yourself with interest rates

If you are borrowing or lending money for any purpose, interest is a very important factor in how this transaction goes. Make sure you know the interest rate and the types you are working with. Most importantly, make sure you have the tools to extrapolate, so you know how much money you are spending or earning on a trade. Doing the math on a loan or investment product with a given interest rate will tell you exactly what to expect during the life of the transaction. And it can help you find your way to financial freedom. To find out more, subscribe to Freedom through wealth e-letter below.