The Interest rate is money that one pays for the use of someone else’s money. Interest is paid by the borrower (debtor) for the use of money that you borrow from the lender (creditor).
The two major criteria to setting interest rates are the riskiness of the investment and what rate is commonly being paid. If you have a good credit rating you might receive a more favourable interest rate when borrowing money.
Interest On A Loan
To begin, we need to become familiar with some lending terms:
- When a person takes out a loan the initial amount is called the principal. The principal is presented by the letter P
- The rate at which that the principal collects interest is called the interest rate and is presented by the letter R. (The rate is often expressed as a decimal and not as a percentage.)
- A loan period occurs over a period of time, represented by the letter T
There Are 2 Types Of Interest – Basic Interest and Compound Interest:
1. Basic Interest (Simple Interest)
- Simple or basic interest is used only for loans and investments of less than one year.
- Simple or basic interest is at a fixed rate over a set time.
- If the time is longer than one year, compound interest will be used instead.
- If you want to take out a small loan for the amount of $3,000 over 5, 6 or 12 months.
- If the length of the loan is 5 months and you are paying simple interest of 3.5 percent per month
Interest =P x R x T (Principal, Interest rate and time) or $3000.00 x .0.35 x 5 = $525.00 - If the length of the loan is 6 months and you are paying simple interest of 3.5 percent per month
Interest = P x R x T (Principal, Interest rate and time)or $3000.00 x .0.35 x 6 = $630.00 - If the length of the loan is 12 months your are paying simple interest of 3.5 percent per month
Interest = P x R x T (Principal, Interest rate and time) or $3000.00 x .0.35 x12 = $1260.00
(NOTE: THESE INTEREST RATES USED HERE ARE USED AS AN EXAMPLE.)
2. Compound Interest
Compound interest is applied when interest is added to the Principal, so from that moment on, the interest added earns interest. The addition of interest to the principal is called compounding. This interest is added every year.
When you have debt with a high interest rate, it is best to pay of the balances with the highest interest rates first.
Taking Advantage of Compound Interest
Most people know that if you put money in a bank, you will get more money over time. The bank is paying you to use your money for investments and loans. The longer the money is in the bank, the more money you will get. It makes sense that if you get put your money in a bank with high interest, you will get more money than if you put it in a lower interest bank.
Compound interest can be used to your advantage by investing in savings account, money market accounts, stocks, bonds or mutual funds.
Any lending institution, such as a bank, is required by law to state its interest rates annually and as compound rather than simple interest.