What Is Interest Rate ?

interest rate definitionInterest rate refers to the amount indicated as a percentage to the amount of the loan paid by the loan recipient for using it during a certain period (month, quarter, or year). From the standpoint of the theory of money, the interest rate is the price of money as a means of saving.

Interest Rate Definition

The interest rate is an expression of the amount of money that the borrower pays for using the borrowed funds, having the form of a percentage of the total loan amount. The IR is always tied to any particular time period for which it will be charged.

In relation to the monetary system as a whole, the interest rate denotes the value of money as an element of monetary accumulations. The IR on the loan forms interest income. Interest income is the profit earned by providing money on credit. However, interest income also exists in the securities market (return on investment).

You can find more useful information regarding the interest rate definition at Monfex.com.

Types of Interest Rates

Depending on whether the rate changes over time, there are fixed and floating interest rates.

The fixed IR is constant, set for a certain period and does not depend on any circumstances. The floating IR is subject to periodic review. The rate change is based on fluctuations of certain indicators. A classic example of such indicators is the London interbank supply rate (LIBOR, the weighted average rate on the London interbank credit market). Accordingly, a floating rate of LIBOR + 5% will mean that the nominal value of the IR is 5% higher than the LIBOR rate.

Depending on the time of interest payments, there are two types of interest rates. The decursive rate is the interest paid in the end along with the main loan amount. The anticipative rate is the interest paid at the time of the loan (in advance) and determined based on the final amount of the debt.

The anticipative rate is more profitable for a lender and a decursive rate - for a borrower. For example, if the IR is 10%, then at a decursive rate with a loan of $1,000 the lender will receive $1,100 at the end of the loan period. At an anticipative rate, it will give the borrower $900, and at the end of the period, they will receive $1,000.

Depending on inflation, there are nominal and real interest rates. The nominal rate is the market IR excluding inflation, which reflects the current valuation of monetary assets. The real rate is the rate adjusted for inflation.

According to the validity period, there are the current and forward rates. The current rate is valid at the time of the conclusion of the contract, for example, a stock contract with a limited period for obtaining a loan. The forward rate acts starting from the day it was established, regardless of the period after which the contract was concluded, and depends on changes in the overall economic situation.

For example, the current rate may be valid for one day, prompting customers to quickly agree to a loan. Meanwhile, the forward rate is established by the bank for a long period, is used constantly in advertising campaigns of loan products, and is valid for the entire selected group of loans.

What Influences Interest Rate

Interest rates typically depend on the following factors:

  • Demand for loan products. The higher the demand, the higher the percentage. Firstly, because the bank will nevertheless have to raise third-party funds in order to serve everyone. Secondly, a bank with a solid reputation will definitely monetize this demand. After all, the main thing for any financial organization is profit. As soon as the general demand for borrowed funds will decline, interest rates will also decline.
  • Loan security. Loans without collateral and guarantors are always riskier, therefore banks insure themselves by higher interest rates.
  • Internal expenses of financial institutions. Remuneration of employees, utility bills, office rent, purchase of consumables and office equipment - all these expenses are included in the cost of banking products.
  • Loan terms. Now almost all loan products allow repaying a loan ahead of schedule without penalties. It used to be the other way around - the bank counted on certain interest rates for a certain time, and therefore early repayment was not welcome.
  • Availability of insurance. It is usually rejected by borrowers, and this item may ultimately affect the rate increase. An uninsured loan and a borrower are a risk for the bank, so it will immediately try to get more at the expense of interest.
  • Risk degree. Checking the borrower is a mandatory procedure for financial institutions. The higher the risk level of the application, the more likely it is that the interest will be sky-high, or even a loan will be refused.

How to Calculate Interest Rate

As a rule, two formulas are used to calculate IR – simple and compound interest.

Simple interest is the accrual of interest at the end of the term - for example, a yearly deposit with interest paid at the end of the deposit term.

Simple interest is calculated as follows: S = (P x I x t / K) / 100, where:

  • I - annual interest rate,
  • t - the number of days for calculating interest on attracted deposits,
  • K - the number of days in a calendar year (365 or 366),
  • P – the initial amount of funds attracted to the deposit,
  • S - the amount of accrued interest.

Compound interest is when interest is capitalized within the term of the deposit (monthly or quarterly) - for example, a yearly deposit, with the interest capitalized during the year.

Compound interest is calculated as follows: S = (P x I x j / K) / 100, where:

  • I - annual IR,
  • j - the number of calendar days in the period following, after the bank capitalizes the accrued interest,
  • K - the number of days in a calendar year,
  • P - the initial amount of funds attracted to the deposit and the subsequent amount, taking into account the capitalization of interest,
  • S - the amount of money due equal to the original amount of borrowed funds plus accrued capitalized interest.

What Is the Interest Rate in the UK

According to the latest data found at TradingEconomics.com, the interest rate in the United Kingdom equals 0.75 as of September 2019. It does not differ from the previous IR that was recorded about a year ago. The UK has one of the world’s lowest “positive” interest rates, followed by Fiji, Jamaica, Israel, and New Caledonia.

Summary

Now you are aware of what is interest rate, how to calculate interest rate, and what is the interest rate in the UK. Visit Monfex.com for more helpful definitions of financial terms.

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