Interest Definition

Interest in simple terms is the amount that is earned by lender in addition to principal provided to borrower. The interest can be earned by lender or paid by borrower. In other words the interest is the rent charged by lender from borrower for using the principal borrowed by borrower.

Interest rate

The percentage that will be applied on the principal amount to calculate the interest amount is called interest rate. For example you might borrow \$5,000 from bank and bank offers you the \$5,000 for three years and in return, it will charge you 6% interest per annum. Now 6% is the rate of interest at which you will pay to bank every year.

Who decides the interest rate?

Normally central banks decide the interest rates for borrowing and lending. These rates are then used to borrow and lend among different banks and banks use these rates for consumer purposes. An example is LiBOR (London Interbank Borrowing Rate).

Denomination

Interest rates are normally denominated in yearly terms; however, the terms of loans may specify the tenure of payments as monthly, quarterly or semiannually. In that case the interest rate will be apportioned accordingly. For example if a bank charges 8% per annum on a quarterly basis, this implies that the quarterly rate will be 2% (8%/4 quarters).

Causes of Interest rates fluctuations

It depends on various factors but supply and demand of money are the major causes of the interest rate fluctuation.

Types and Application:

Simple Interest

It is the most simple and most commonly used interest in our routine life. People invest money in fixed deposit plans with banks at a percentage of interest based on simple interest basis. The interest on such plans is calculated by multiplying principal (P) with interest rate (R) multiplied by number of periods (T) divided by 100. Simple interest is paid by the borrower at the end of the loan term along with the repayment of principal amount borrowed. The important thing to note here is that simple interest is calculated on principal amount only. For example if a principal of \$50,000 was borrowed by A from Bank B for 5 years @ 6% per annum then the interest will be calculated using the following formula.

Simple interest = P x R x T

Simple interest = \$50,000 x 6% x 5

= \$15,000

Compound Interest

Compound interest is calculated on principal and interest both. In other words the interest keeps on adding in principal after every period. In this case after every year the principal amount will grow and will keep on increasing every year until the maturity of the loan. Hence the interest amount will change every year as the principal amount is changing every year. For example if a principal of \$50,000 was borrowed by A, from Bank B for 5 years @ 6% compounded annually then the interest will be calculated using the following formula.

Compound interest = P x (1+R/100)T - P

Compound interest = \$50,000 x (1+6%/100)5 - \$50,000

= \$16,911.3

Fixed Interest

By fixed interest means the percentage of interest rate is fixed and does not change over time. This is commonly used in corporate debt arrangements and mortgage loans.

Variable Interest

This interest rate varies with respect to a monitoring body such as a central bank. The rates may vary (increase/decrease) weekly, monthly, quarterly or semiannually as required by the index value.

Prime interest

This type of interest is not common and the financial institution like banks offer loans to its creditworthy customers at lower than commercial borrowing rates.

Discount Interest

It is typically the rate at which central banks lend money to commercial banks. This rate is used in time value of money and discounting cash flows purposes.

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