What are Interest rates, Types and Their Implications for Borrowers


The interest rate is the amount a lender charges a borrower and is expressed as a percentage of the loan's principal. Typically, the interest rate on a loan is expressed annually as the annual percentage rate (APR).

What are Interest rates

A bank or credit union may also apply an interest rate to the earnings from a savings account or certificate of deposit (CD). APY actually refers to the interest earned on these deposit accounts.

• The interest rate is the amount charged by a lender to a borrower in addition to the principal for the use of assets.

•The interest rate also applies to the amount earned on a deposit account at a bank or credit union.

Most mortgages use simple interest but some loans use compound interest, which will be applied not only to the principal but also to the accumulated interest from previous periods.

• The lender will charge a borrower with a low risk rating a lower interest rate. A loan with a high risk rating (higher risk) will have a higher interest rate. The annual percentage yield is the interest rate earned on a savings account or CD at a bank or credit union. CDs and savings accounts use compound interest.

Understanding Interest Rates

In essence, interest is a fee amount charged to the borrower for the use of an asset received. Borrowed assets can include cash, consumer goods, vehicles, and real estate. Consequently, an interest rate can be considered the "cost of money"; higher interest rates make borrowing the same amount of money more costly.

Thus, interest rates apply to the majority of lending and borrowing transactions. Individuals borrow money to finance the purchase of homes, the completion of projects, the establishment or continuation of businesses, and college expenses. Businesses obtain loans to finance capital expenditures and expand their operations through the acquisition of fixed and long-term assets such as land, buildings, and equipment. By a predetermined date, borrowed funds are either repaid in a lump sum or in periodic installments.

The interest rate is applied to the loan's principal, which is the amount borrowed. The interest rate represents the cost of borrowing for the debtor and the rate of return for the lender. Typically, the amount to be repaid exceeds the amount borrowed because lenders require compensation for losses of use of the funds during the loan period. Instead of providing a loan, the lender might have invested the funds during that time, and that would have generated income from the asset. Interest is the difference between the total amount repaid and the original loan amount.

When the lender deems the borrower to be low risk, the borrower will typically be charged a lower interest rate. If the borrower is deemed high risk, they will be charged a higher interest rate, resulting in a more expensive loan.

A lender typically evaluates risk by reviewing a potential borrower's credit score; therefore, it is essential to have an excellent credit score if you want to qualify for the best loans.

Simple Rate of Interest

If you borrow $300,000 from the bank and the loan agreement specifies that the interest rate is 4% simple interest, you will have to repay the bank the original loan amount plus (4% x $400,000) = $400,000 plus $16,000, or $416,000.

The above example was calculated using the annual simple interest formula:

Simple interest (S) = principal (P) X interest rate (R in percentage) X time (N)

The individual who took out a loan will owe $12,000 in interest at the end of the year, assuming the loan was only for one year. If the loan term considered was 30 years, the interest payment would be as follows: Simple interest = $400,000 x 4% x 40 = $480,000

A 4% annual simple interest rate results in an annual interest payment of $20,000. After 30 years, the borrower would have paid $480,000 in interest, which explains how banks make money.

Compound Interest Rate

Some lenders prefer the compound interest method, which increases the amount of interest paid by the borrower. Compound interest, also known as interest on interest, is applied to both the principal and accumulated interest from prior periods. The bank assumes that the borrower will owe principal plus interest at the end of the first year. The bank also assumes that the borrower will owe the principal plus interest for the first year plus interest on interest for the first year at the end of the second year.

The interest payable when compounding is greater than the interest payable when using simple interest. The monthly interest rate is calculated by adding the accrued interest from the previous months to the principal balance. For shorter intervals, the calculation of interest is equivalent for both approaches. However, as the duration of the loan increases, the disparity between the two methods of calculating interest grows.

At the end of 30 years, the total amount of interest owed on a $400,000 loan with a 4% interest rate is nearly $900,000.

Use the following formula to determine compound interest:

Compound interest equals p times [(1 plus the interest rate)n minus 1].


n = number of compounding periods p = principal

Compound Interest and Savings Accounts

When money is saved in a savings account, compound interest is advantageous. The compounded interest earned on these accounts compensates the account holder for allowing the bank to use the deposited funds.

For instance, if you deposit $1,000,000 into a high-yield savings account, the bank can use $600,000 of these funds to finance a mortgage. To compensate you, the bank deposits 1% annual interest into your account. So, while the bank collects 4% from the borrower, it gives 1% to the account holder, resulting in a net interest payment of 3%. In essence, savers lend the bank money, which then provides borrowers with funds in exchange for interest. The snowball effect of compounding interest rates, even at rock-bottom levels, can help you build wealth over time.

Borrower's Debt Cost

While interest rates represent interest income for the lender, for the borrower they represent the cost of debt. Companies compare the cost of debt to the cost of equity, such as dividend payments, to determine the least expensive source of funding. To achieve an optimal capital structure, the cost of capital is evaluated, as the majority of businesses finance their capital through debt and/or equity issuance.


Consumer loan interest rates are typically expressed as annual percentage rates (APR). This is the rate of return that lenders require for access to their funds. The interest rate on credit cards, for instance, is expressed as an APR. In our example, the APR for the mortgage or borrower is 4 percent. The APR does not account for annual compound interest.

The APY (annual percentage yield) is the interest rate earned on a savings account or CD at a bank or credit union. This interest rate accounts for compounding.

How Are Interest Rates Determined?

The interest rate charged by banks is determined by a number of variables, including the economic climate. The central bank of a country (e.g., the Federal Reserve in the United States and each country have their own Federal Bank) institutes the interest rate, which each bank uses to determine the APR range it offers. When the central bank establishes high interest rates, the cost of debt increases. When the cost of debt is high, borrowing is discouraged and consumer demand is reduced. Additionally, interest rates tend to increase alongside inflation.

To combat inflation, banks may implement higher reserve requirements, resulting in a tighter money supply or an increase in credit demand. In an economy with a high interest rate, people save their money because the savings rate is higher. The stock market suffers because investors would rather invest in higher-yielding savings accounts than in the stock market, which offers lower returns. Additionally, businesses have limited access to capital funding via debt, resulting in economic contraction.

Economies are frequently stimulated during periods of low interest rates because borrowers have access to cheap loans. Since savings interest rates are low, businesses and individuals are more likely to spend and invest in riskier assets, such as stocks. This spending stimulates the economy and injects capital into the capital markets, resulting in economic expansion. While governments prefer low interest rates, they ultimately lead to market disequilibrium, where demand exceeds supply and causes inflation. Inflation causes an increase in interest rates, which may be related to Walras' law.

Interest Rates and Discrimination

Despite laws prohibiting discriminatory lending practises, such as the Equal Credit Opportunity Act (ECOA), systemic racism persists in the United States. A Realtor.com report published in July 2020 found that homebuyers in predominantly Black communities are offered mortgages with higher interest rates than homebuyers in predominantly white communities. Its analysis of 2018 and 2019 mortgage data revealed that the higher rates increased the interest on a typical 30-year fixed-rate loan by nearly $10,000 over its lifetime.

The Consumer Financial Protection Bureau (CFPB), which enforces the Equal Credit Opportunity Act (ECOA), issued a Request for Information (RFI) in July 2020 in an effort to identify opportunities for enhancing ECOA's efforts to ensure nondiscriminatory access to credit. "Clear standards protect African Americans and other minorities, but the CFPB need to take action for ensuring lenders and others comply must with the law," said Kathleen L. Kraninger, the agency's director.

Why are 30-year loan rates higher than 15-year loan rates?

Interest rates are determined by default risk and opportunity cost. Longer term loans and obligations are rather riskier as there is a chance that the borrower has more time to default. Likewise, the opportunity cost is greater over longer time periods, as the principal is unavailable for use elsewhere.

How Does the Federal Reserve Use Interest Rates to Influence the Economy?

Along with other central banks around the world, the Federal Reserve uses interest rates as a monetary policy instrument. By increasing the cost of borrowing among commercial banks, the central bank can affect a variety of other interest rates, including those on personal loans, business loans, and mortgages. This increases the cost of borrowing in general, reducing the demand for money and cooling a hot economy. In contrast, a reduction in interest rates makes it easier to borrow money, which stimulates spending and investment.

Why do bond prices react negatively to changes in interest rates?

A bond is a type of debt instrument that typically pays a fixed rate of interest throughout its life. Suppose that the prevalent interest rate is 5%. If a bond has a par value of $1,000 and an interest rate (coupon) of 5%, it will pay bondholders $50 per year. If interest rates rise to 10%, the yield on newly issued bonds will double, to $100 per $1,000 face value. Existing bonds that pay only $50 must be offered at a steep discount if they are to be purchased. Similarly, if interest rates fall to 1%, new bonds will pay only $10 for every $1,000 in face value. Therefore, a $50 coupon bond will be in high demand, and its price will be quite high.


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