How Interest Rates Work

Understanding Interest Rates

All of us know about interest rates. But most of us do not understand how it works as it comes with varied complicated concepts and details. It is however important to know that it is in our best interest to comprehend the finer workings of interest rates so as to be able to make good financial decisions and thereby saving lots of money over time with regards to debt and loans.

First let us begin with the definition of interest. It is the amount paid by borrowers for using a lender’s money. With reference to the money owned by you (like your money in a bank account), interest is the money that the bank (other lenders) pay you for using your money.

Simple Interest

It is the simplest form of interest rates. It is calculated by the formula A = P (1 + rt), where A is the total amount repaid with interest over time; P is the principal amount of loan taken; r is the rate of interest; and t is the tenure of the loan.

For example, if you borrow $2000 for a period of 2 years at an interest rate of 4 percent, then the interest paid on the loan is $160, and the total amount repaid is A = P (1 + rt)

i.e., A = 2000 (1 + (0.04 * 2))

A = 2000 (1 + (0.08))

A = 2000 * 1.08

A = 2160

Simple interest is not the only type of interest rate. There are other types of interest rates like APR, auto loan interest rates, credit card interest rates, mortgage loan interest rates, etc.

APR (annual percentage rate)

Annual percentage rate or APR may also include additional charges such as fees related to the loan, etc. Thus, APR is often a bit higher as compared to base simple interest rates.

APR is used to understand and measure the overall cost of a credit or loan. Borrowers need to look at both the simple interest rate as well as the APR when searching for varied loans and credit cards, etc. It is better to look at the APR when comparing varied loan options as it offers borrowers a glimpse of the final cost of the loan in one simple figure.

APR can be calculated by:

Adding the total interest paid on loan with all fees related to the loan (x)

Dividing (x) with the total loan amount (principal) (y)

Dividing (y) with the tenure of the loan in terms of number of days (z)

Multiplying (z) by 365 (a)

Multiplying (a) by 100

Thus for example, if you borrow $2000 for a period of 2 years at an interest rate of 4 percentand an extra $200 as administration fee, then the APR is:

200 + 160 = 360

360/2000 = 0.18

(0.18/730) * 365 = 0.09

0.09 * 100 = 9

The APR for this loan is 9 percent. It is higher than the simple interest rate of 4 percent as it includes all the extra associated loan costs.