3 Quick Points to Simplify Interest Rates
A rate you should be familiar with
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An interest rate is an amount a lender charges a borrower and is a percentage of the principal, which is the amount loaned. The interest rate on a loan is typically noted annually, known as the annual percentage rate (APR). Interest rates can also apply to the amount earned from a savings account or certificate of deposit (CD), known as annual percentage yield (APY). When it comes to simplifying interest rates, the following three points do exactly that:
1. Interest Is a Charge to the Borrower for Using an Asset
2. Simple Interest vs. Compound Interest
3. Central Banks Sets Interest Rates
1. Interest Is a Charge to the Borrower for Using an Asset
Interest is essentially a charge to the borrower for the use of an asset. Assets borrowed can include cash, consumer goods, vehicles, and properties. When you take out a loan to purchase a vehicle, you are charged an interest rate known as the APR to use the vehicle and eventually gain full possession of the vehicle after paying off the loan. When you put money in a savings account that offers you an APY, the financial institution you are with is borrowing your money to then lend to borrowers to make money.
2. Simple Interest vs. Compound Interest
Simple Interest = Principal * Interest Rate * Time while Compound Interest = Principal * [(1 + Interest Rate)^n -1] where n = the number of compounding periods.
Using simple interest, let’s say Joe has been provided with an interest rate of 4% on a 30-year mortgage for a $400,000 home. In using simple interest, after 30 years, Joe will have paid his lender $480,000 total.
Using compound interest, let’s say Mary receives an interest rate of 1% from her $10,000 deposit in her savings account compounded monthly. In using compound interest, after one year, Mary’s deposit would be worth $10,100.46 if she does not add additional money.
3. Central Banks Sets Interest Rates
Several factors determine the interest rates charged by financial institutions, and one of those key factors is the interest rates set by a country’s central bank. In the…
