Interest is a financial fee for borrowing a set amount of money. This is the amount of money that a borrower owes a financial institution for borrowing them money. It is typically calculated as an annual percentage rate figure also known as (APR).
This rate can be impacted by inflation rate, amount of time that the money is borrowed from a lender, liquidity, and risk of default. Interest can express a person or stockholders ownership percentage in a corporation with a set percentage that may vary.
How Does Interest Work?
There are two different common types of interest which include simple and compound interest. Each of these types can be applied to various loans and affect the amount of money the borrower would pay back.
When you are calculating interest, there can be a number of factors to consider. With interest you will have to measure the amount of inflation that may affect the amount that is owed back. The rate of inflation and interest rates have an inverse relationship.
Inflation refers to the rate in which the price of goods will increase. For example, when interest rates are high the economy is more sluggish and inflation tends to decrease.
Additionally, borrowers need to be aware of the potential risk that have if they default on the loan. Defaults can lower your credit score which will make it more difficult to get approved for another loan in the future. They also can affect secured debt, such mortgages, which are backed by collaterals. If the borrower defaults, then the bank will be able to seize their collateral to pay off your loan.
How Do I Earn Interest?
You will earn interest whenever you lend money or put funds inside of an interest-bearing bank account. When you have money saved up you earn interest from it by letting it sit in your bank account.
Banks will offer low rates to encourage people to lower borrowing costs to increase spending amounts. Using high interest accounts is a great way to earn profit.
Online banks tend to have lower costs and offer very high interest rates. Whether as, traditional banks are very different and typically have lower rates that you can’t benefit from as much.
Annual Percentage Rate (APR)
An Annual Percentage Rate would be your interest rate that is set as a yearly rate. Borrowers look at their APR so they have a good idea of how much they have to pay for the loan.
With fixed APR, it does not change during the timeline of the loan. Fixed APRs are more predictable and they would include things such as mortgages and personal loans.
In comparison, variable APRs are tied to an index interest rate and can fluctuate over time. These are more unpredictable and they will increase as interest goes up.
Types of Interest
There are various types of interest that you need to be aware of prior to borrowing or taking out any loans.
Simple
Simple interest calculate the principal portion of a loan. How one would do this is by following this formula:
Simple Interest = (P * R * T)/100
Where:
P = Principal amount
R = Rate of interest
T = Number of Periods
This form of calculating interest is usually used for short-term loans or easy calculations. They are generally used in single-period settings since they can be inaccurate for longer term loans.
Compounding
Compounding interest is essentially the interest you gain from your interest. To determine the returns this calculation considers the initial deposit, contributions, time span, rate of return and the compound frequency of a loan.
The formula consists of:
Compound Interest = P * (1+ (R/N)) ^ N*T
Where:
P = Principal balance
R = Interest rate
N = Number of periods interest is applied
T = Number of periods
This form of interest is used to grow your savings over time. This is because interest continues to accrue and get added into your account over time.
You can leave money in the stock market to allow your returns to grow over time. But, they can lose value over time if the stock is performing poorly.
Accrued
Accrued interest is the amount that is incurred over a period of time that has to be paid back. It is the amount of bond interest that has built up over time since the borrower last made a bond interest payment.
Its formula consists of:
Accrued Interest = FV * (R/365) * N
FV = Face Value
R = Coupon rate
N = Accrual period
Accrued interest can build up for either a borrower or a lender. At the end of an accounting period, accrue interest will be noted on the following pay period because it has yet to be paid back.
Learning More About Interest
Interest is the fee for borrowing a set amount of money. The most common types of interest included simple, accrued, and compounding.
Financial advisors can help you understand how to take advantage of interest rates and save up your money quickly. You should think about consulting a financial advisor to help you build your wealth and plan for the future.