Interest Rates
A charge on profits is not always welcomed, but all appreciate income in any form. Interest is income earned on the funds utilized by the person holding the same.
What is Interest Rate?
Interest rate is the amount charged over and above the principal amount by the lender from the borrower. In terms of the receiver, a person who deposits money to any bank or financial institution also earns additional income considering the time value of money, termed as interest received by the depositor.
Interest rates on borrowings and deposits may defer considering the purpose and to whom the amount is given.
Interest Rate on Borrowings
Borrowing has become prevalent in terms of the smooth functioning of trade practices and proper regulation of money in the economy, and the process of borrowing money has also been relaxed to help businesses grow.
Borrowings not only ease money problems but also helps the borrower in planning the finances better.
Interest rates on borrowings are fixed depending on the type of borrower and the credit rating associated with him. Suppose the borrower has a low credit rating. In that case, it might be possible that banks might not lend money at all or by charging extreme interest rates or keeping the double amount of collateral security.
Private lenders also provide loans to borrowers, but their terms and conditions might differ from the conventional loans obtained from banks or financial institutions. They might charge hefty interest on the sum lent with certain other additional conditions.
In the event of default, banks or financial institutions stop charging interest and reclassify the assets in their books. In the event of pre-payment, a penalty and interest are charged from the borrower to avoid the loss of regular income considering the time value of money.
Interest rates on deposits
People deposit excess money in banks and financial institutions to earn additional income as interest depending on the time value of money and the compounding effect.
Interest can be earned as simple interest and compound interest.
Simple Interest
It is a simpler form of computing interest on the principal amount as the term of the loan is considered for that year only, and interest is charged or provided every year on the same original sum deposited or lent, as applicable.
It is easier to calculate, and a layman can also understand its calculation.
For example, if the original principal amount is $100 and the interest rate is 10% per annum for one year, then the interest will be computed as under-
= $ 100 * 10% * 1
= $ 10
I.e. Principal Amount * Interest Rate * Time (Duration of loan/deposit)
So, as per the above calculation, $110 will be paid or received by the borrower or depositor at the end of one year.
Compound Interest
Compounding, as defined in the dictionary, refers to “reckoning interest on previously accumulated interest”. A layman might not well receive it as it might sound a bit complicated compared to simple interest computation.
Let’s have a look at the formula by which compound interest is computed-
= Principal Amount * [(1 + Interest Rate) n – 1]
Where n= number of compounding periods
It might still not be clear to many. But by closely analyzing the formula and the definition of compounding, one can ascertain the meaning.
Interest rates are useful when compounded as it considers the time value of money as interest is also provided or charged on the amount already received as well as on the principal amount, so there is no loss of interest on the deposited sum.
Interest on interest is the main benefit of compounding and can be beneficial for the depositors as interest rates on deposits are generally lower than interest on borrowings.
Certain lenders also tend to charge interest on a compounding basis depending on their policy or the borrower's credit rating.
Debt vs Equity
Equity is the owned funds of the company, and the company is not liable to its owners for such funds. Debt is the borrowed funds of the company on which the company pays interest mandatorily on the pre-defined interest rates.
Companies should not rely a lot on borrowed funds as it puts significant doubt on the company's ownership. Debt-equity ratio ranging between 0.5-1.5 is considered ideal in the industry, but it can change depending on other factors.
What are APR and APY? Are they both the same?
APR stands for annual percentage rate, which is used for interest rates on consumer loans that the lenders demand from the borrowers. APY stands for annual percentage yield, which is used when interest is earned from funds deposited in banks.
What are the factors affecting interest rates?
Interest rates are affected based on the credit score of the borrower, income ratio, market factors, inflation, etc.
What is the main difference between simple and compound interest?
Simple interest differs from compound interest mainly in terms of charging interest on the accumulated funds that are done in compounding and are ignored in simple interest calculation.
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