What is an Interest Rate?

//What is an Interest Rate?
What is an Interest Rate? 2017-10-05T03:22:50+00:00

Definition: An interest rate, usually a percentage, is the amount charged by a lender that a borrower must pay for using the lender’s principal. In other words, this is the extra amount beyond the premium that the borrow must repay the lender.

What Does Interest Rates Mean?

What is the definition of interest rate? You can think of this like compensation to the lender for foregoing the use of his asset for a period of time. For instance, if the bank loaned you $100,000 at 5 percent interest, they would be out $100,000 for the duration of the loan. Thus, they need to be compensated for this loss of opportunity. By taking the loan, you agree to pay them 5 percent interest in addition to the $100,000 principal for use of their money.

There are a few elements one needs to know in order to completely understand rates. First, it is important to understand the types of interest there are: simple and compound. Simple interest is based purely upon the principal earned.

Simple interest is always stated in terms of years or annual rates. If Johnny takes out a loan of 10 USD and there’s a 20 percent rate on that loan, Johnny will owe $2 in interest at the end of the year ($10 principal x 20% = $2). If Johnny does not pay the principle after the second year, Johnny will owe another $2 in interest. This type of interest plan confers the most advantage to the borrower, because the amount owed will not fluctuate much. Simple interest rate formula: Principal x Rate x Number of years

Compound interest is slightly more complex. If Johnny takes out a 20% $10 loan, Johnny will owe $2 of interest at the end of the first year. However, if Johnny does not make any payment on that loan by the end of the second year, Johnny will owe 2% of the principal ($10) in addition to 2% of the interest from the year before ($2. So now Johnny owes $10 of principal + $2 of year 1 interest + $2.40 (.20 x 12) of year 2 interest = $14.40 total. Now you can see where the name comes from. The interest compounds on itself overtime.

This type of interest plan is most advantageous for the loaner because they will reap greater reward if the borrower is delinquent on payment or has deferred payment for a period of time (i.e. student loans). It is important to note that some interest plans will compound the rates at shorter intervals than the year provided in this mini-example.

Compound interest rate formula: P [ ( 1 + i ) n – 1]

P=principal, i=interest rate, n=compound periods

Businesses are concerned with rates because they often need to borrow money to expand and grow. Occasionally, businesses will loan money out to borrowers as well. This can be a great way for a business to receive additional revenue if the borrower is determined to be a responsible individual because a sizeable loan with a compound rate can reap substantial dividends for a company over time. Interest rates can also cripple businesses that are unable to pay back loans or have outstanding loans that have grown to an unmanageable proportion due to years of deferred payment.

Example

Tracy is a student at Spelman College. Tracy, like many college students, borrowed student loans. Tracy borrowed all the money she needed for college up front as a freshman. Her loans totaled $20,000 with a compounding 5% rate. Because Tracy was in school, the loan company allowed her to defer payments until her graduation (4 years).

Here is how much Tracy will owe.

Compound interest rate: P [ ( 1 + i ) n – 1]

For Tracy this read as: X = 20,000 [ 1 + .05 ) 4 – 1] , meaning X = 4,310.125.

Thus, Tracy would owe $24,310 at the time of her graduation.

Summary Definition

Define Interest Rates: Interest rate means the percentage of principal that must be paid to a lender for the use of his asset.