Types of Interest
It is the money a person or financial institution receives from the borrower.
What are the Different Types of Interest?
There are different interest rates per society’s needs: simple Interest, compound interest, fixed interest, variable Interest, accrued Interest, discounted interest rate, prime interest rate, and annual percentage rate.
Interest is the money received by a person or financial institution known as the lender for lending money or any other security to the borrower.
The borrower must pay the interest using the agreed rate to the lender.
Simple Interest Rate
Simple interest is the amount of interest paid on the outstanding principal amount. Banks and financial institutions generally charge it to their customers. The formula calculates the total amount:
A = P * ( 1 + RT )
or
A = P * R * T
Where,
- A = Final Amount
- P = Initial Principal Balance
- R = Annual Interest Rate
- T = Time taken
Most personal loans, auto loans, and short-term loans are calculated using a simple interest formula. It is one of the widely used methods for calculating interest payments, given its simplicity.
For example, Adam borrows $3000 from Mary with an annual interest rate of 7%, noting that he borrowed this for three years. The interest payment for each year will be calculated by the formula mentioned above:
Interest for 1st year = $ 3,000 * 7% = $ 210
Interest for 2nd year = $ 3,000 * 7% = $ 210
Interest for 3rd year = $ 3,000 * 7% = $ 210
The total interest given by X to Y at the end of the 3rd year will be $210 + $210 + $210 = $ 630.
Simple Interest vs. Compound Interest
The primary distinction between simple interest and compound interest is that simple interest is calculated on the principal amount alone. In contrast, compound interest is calculated on the principal amount plus interest compounded over a period.
The return received in simple interest is much lesser when compared to compound Interest.
The growth remains relatively uniform in simple interest, whereas growth increases rapidly in compound interest.
Compound Interest Rate
Compound interest is also known as interest on interest. The interest rate is charged on the principal amount and accrued interest. The formula calculates the total final amount:
A = P (1 + R / N) NT
Where,
- A = Final Amount
- P = Initial Principal Balance
- R = Annual Interest Rate
- T = Time
- N = Number of times interest applied per period
Banks and corporations widely use this formula to calculate investments that involve compounding.
For example, suppose Adam has invested $5000 at 10% interest for three years. The total amount he will be getting in subsequent years is as follows:
Amount for 1st year = 5000 * 10% = 500
Amount for 2nd year = 5500 * 10% = 550
Amount for 3rd year = 6050 * 10% = 605
More compounding periods and longer duration will create significantly higher returns than simple interest because, in compounding, you receive interest on interest.
Fixed Interest Rate
Fixed interest is static, and it doesn’t change with time. As the interest rate is fixed/ constant throughout the period, it gives a clear understanding to both the lender and borrower. The most common example of fixed interest is government bonds.
Investors get a fixed rate of return on their investments made in bonds which helps in accurately estimating the future amount they receive. The following formula calculates it:
A = P * R
Where,
- A = Final Amount
- P = Initial Principal Balance
- R = Annual Interest Rate
Fixed interest sometimes makes loans or mortgages costlier than variable interest because it avoids risk and other factors, as the claim is constant throughout, keeping other factors aside.
The main advantage of a fixed-rate home loan is the certainty that your repayments will not change during the fixed interest period. This way, you’ll know exactly how much money you need each month and can budget confidently.
But on the other hand, changing your loan may be difficult or expensive. If you refinance during the fixed term, you may be subject to a penalty or break costs.
For example, a person took a home loan from a bank of $100,000 at the rate of 10% for 20 years. He will pay $10,000 (100,000*10%) at the end of each period. He will continue to pay this amount to the bank for 20 years.
As you can see, the interest rate is constant throughout, and a fixed interest rate makes it easy for the borrower to plan his budget and make the payment accordingly.
Variable interest Rate
When it comes to variable interest, the interest rate is not static and fluctuates directly to the changes in an index. They change daily, monthly, or annually depending on the type of security and industry average. They are the opposite of Fixed interest.
This borrower has to pay interest linked to the interest of the base level of the prime rate, indices (such as LIBOR or Feds Fund rate), or any other security. Equity and Adjustable-rate mortgages (ARM) are the best examples.
The variable interest rate has pros and cons, depending on the prime interest rate. There can be two scenarios:
1) Prime Rate increases
When the prime rate increases, the variable interest rate also increases. Thus borrowers have to pay a higher rate of interest.
2) Prime Rate decreases
When the prime rate decreases, the variable interest rate also decreases; thus, the interest rate will go down.
Calculation: You have to calculate the simple interest of each period with a different rate and add all of them to get the final value.
For example, a person took a home loan from a bank of $100,000 at the rate of 10% for 20 years.
There was a contract that the borrower had to pay interest for the first four years at a fixed rate, and after four years, the interest will be on a variable basis based on the prime interest rate or base rate.
The borrower will continue to pay $10,000 for the first four years. After four years, if the prime interest rate increases, let’s suppose 12%, he will pay $12,000, whereas if it decreases to 8%, the borrower will pay $8,000.
Accrued Interest Rate
Accrued interest is also known as accumulated interest. It slowly starts from the date it is issued to the end of the period. It is owed to creditors over time.
For example, let’s suppose the borrower must pay $60 at the end of the month, which means he needs to pay $2 daily. On the 15th day, the accumulated interest will be $30, though he will pay this amount at the end.
Purpose: The revenue recognition requires interest incurred that will be paid in the future to be disclosed on statements or be part of the deductible business expenses for the period in which it was incurred.
When accruing interest, the ultimate goal is to ensure that the transaction is accurately recorded in the appropriate period.
Simple interest is paid periodically per the agreements settled by the lender and borrower. In contrast, accrued interest is owed to the lender over time and steadily accumulates till the end of the period.
Discount interest rate
It is the rate at which the central government lends money to other banks and financial institutions for a short period (a single day). This interest rate is meant for banks only and does not apply to the general public.
Central banks lend money at a discounted rate or lower than what is prevailing in the market. Discounted interest rate helps banks during crisis or fund shortages to rectify liquidity problems or to cover lending capacity.
Sometimes, the term “discount rates” is used while preparing a company’s DCF models and valuation, representing the expected return rate for an investment.
The benefits of discount rates include calculating the potential value of an investment, calculating the time value of money, comparing various investments, investment yield, and opportunity cost, and determining risks.
A high discount rate indicates that an investment is risky and may not be appropriate for all investors. However, some investors are willing to take risks in exchange for higher potential returns.
A discount rate is frequently confused with an Overnight Rate. A discount rate is the interest rate charged by the central bank on loans made to commercial banks, whereas the overnight rate is the interest rate charged when banks lend funds to one another.
For example, when loans are more than deposits in banks, these banks approach the central bank to grant them a certain amount at a discounted rate to cover their liquidity.
Prime Interest Rate
Prime interest rate is meant for creditworthy customers, generally given to customers with a high credit rating. However, not all customers can benefit from a prime interest rate.
The rate is linked with central bank lending rates, which are generally lower than usual borrowing/lending rates.
For example, suppose a businessman has a good relationship with the bank and a good repayment history. When he approaches banks to borrow money, banks will lend the amount at a prime rate because of their good relations.
Annual Percentage Rate (APR)
It is the total interest on the amount of loan borrowed, which is calculated annually (365 Days). They are primarily associated with credit card companies and credit card payment methodology.
It is calculated on the total interest pending until the last date. It is expressed as the prime interest rate, and banks or lender charges are added. This methodology is used when lenders carry forward their amount balance rather than fully paying it.
The formula gives this:
APR = [((F + I/ P) / N ) * 365 ] * 100
Where,
- F = Fees
- I = total interest paid over the life of borrowed funds
- P = Principal balance
- N = Number of days
This formula can be used for comparing loans as well.
For example, let’s say a person has a credit card with a 12% Annual Percentage Rate (APR). It means for 12 months, the rate is 1% per month.
As all months do not have the same Number of days, the APR will be divided by 365 to get the Daily Periodic Rate (DPR). The interest will be calculated by multiplying DPR with the daily card balance.
Further, it will be multiplied by the Number of days in the billing cycle to get the desired results.
Types of Interest FAQs
Negative interest rates are a form of unconventional monetary policy tool where interest rates fall below 0%. Under this strange policy, borrowers are credited with interest payments rather than debiting from their accounts.
This usually happens in a country with a high chance of deflation in the economy. For example - Denmark, Sweden, Switzerland, Japan, and some parts of Europe.
It is the amount of money borrowed from banks and other financial institutions used to purchase a flat, plot, or any property. The borrower usually pays the loan amount with interest charged on it on a monthly, quarterly, or annual basis.
This periodic payment is known as installments or EMI, which varies from 8 to 25 years. Home loans are also known as mortgages.
Central banks are responsible for formulating economic and monetary policies in the country. It also sets several interest rates to control the money supply. It has the power to produce and distribute money in the country.
It’s a home loan on which a variable interest rate is charged. In an adjustable-rate mortgage, the initial interest rate is fixed for a period of time, and the rate on the balance amount is set weekly, monthly, or yearly.
Researched & authored by Tanishq | LinkedIn
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