What Is Interest
In finance and economy, interest is the income received by the owner of the funds (e.g. a bank) from temporarily providing them to other economic entities. In other words, it is the monetary reward of the lender for the provision of a loan. It represents the compensation paid for the use of financial resources and is usually expressed in the form of an annual interest rate.
For example, let’s suppose that you take a loan of $100 and should repay $110 in a year. The principal amount of the loan is $100, interest income is $10, and the IR is 10% (because $10/$100 = 0.10).
The interest received by the capital owner is determined by the interest rate, the amount of which is defined by the terms of the agreement between the lender and the borrower.
Interest depends not only on the IR value, but also on the calculation method. So, if interest is accrued each time, which does not increase the amount of the initial deposit, we are talking about simple interest, and with the capitalization of interest - about complex one.
What Is Interest Rate
The interest rate is the ratio of interest to the amount of the loan.
The market IR is formed either as a result of the interaction of supply and demand in the credit market or by using the bond market.
In the case of a credit market, decisions of lenders depend on changes in interest rates in this market. In the case of a bond market, the higher the price of bonds, the less a buyer wants to purchase them and the more the sellers want to offer. The price of bonds changes inversely to changes in interest rates. Therefore, the volume of demand for bonds is directly related to the IR whereas their supply has an inverse relation to the interest rate.
The main factors of demand for a loan are as follows:
- The expected rate of return (as the company profit increases, so do the investment and demand for a loan).
- Expected inflation (with rising inflation and constant nominal rates, real interest rates decrease, and there is an increase in demand for a loan).
- The volume of public debt (government borrowings can be so great for any value of interest rates that they will become the main determinant of the credit market).
Loan offer factors are determined by the following factors:
- The level of welfare (its growth leads to an increase in the loan offer).
- The expected return on assets (with a future increase in interest rates and a decrease in the yield of bonds, the loan offer decreases; with a possible future increase in the price of shares and assets, the loan offer decreases), due to the expected inflation rate;
- Risk (in an uncertain situation with a future change in the IR, creditors will increase interest due to inflation);
- The liquidity of bills and bonds.
In the UK, the main IR is the so-called interest rate on repo transactions (Repo rate). It is the rate at which the Bank of England issues short term loans against securities.
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Nominal Interest Rate
IR is typically evaluated in two projections: nominal and real values.
The nominal interest rate is the interest payable annually for a loan. The monthly loan installment results from a fixed repayment and the nominal IR. Credit institutions are required by law to specify the real interest rate, which also includes the processing fees, in addition to the nominal IR. Therefore, the annual percentage rate should be used to compare different offers.
In the field of construction and real estate financing, the nominal or borrowing rate is used to calculate the interest expenses. The real interest rate, on the other hand, is an arithmetic value that is intended to express the actual loan and loan costs incurred. In a direct comparison of credit offers not only the nominal interest rate, but the effective interest rate is the decisive factor.
The dependence of the nominal and real rates received its mathematical reflection in the Fisher equation, which looks as follows:
Nominal rate = Real rate + Estimated inflation rate
The Fisher effect is mathematically described as follows: The nominal rate changes by the amount at which the real rate remains unchanged.
Equality of the nominal rate and the real one is possible only with the complete absence of deflation or inflation. This state of affairs is almost unrealistic and is considered in science only in the form of ideal conditions for the functioning of the capital market.
Nominal Compound Interest Rate
Most often, the nominal rate is applied when lending due to a dynamic and competitive loan market. Trying to minimize their risks, banks prefer to provide long term loans in foreign currency and short term loans in domestic currency.
In order to correctly assess the estimated income from the use of financial resources for a long period of time, economists recommend considering compound interest. When using the compound interest method, at the beginning of each new regulatory period, profit is accrued for the amount received based on the results of the previous period.
Any market mechanism in a volatile environment, especially the domestic economy, is always subject to high risks, be it a loan agreement or investment in securities, opening a new business or depository cooperation with a bank. When evaluating potential profits, it is necessary to consider external factors and the real state of the market. Based only on nominal returns, you can make a wrong, obviously disadvantageous or even potentially disastrous financial decision.
Interest refers to the monetary reward of the lender for the provision of a loan. The interest rate is the ratio of interest to the amount of the loan. The nominal rate consists of the real rate and the estimated inflation rate.
Now you are aware of what is interest, what is interest rate, and how the nominal interest rate differs from the real one. Stay tuned with more helpful financial definitions by visiting our dictionary at https://www.monfex.com/financial-dictionary