The cost of borrowing money is known as interest. When an individual or a business takes out a loan, the money they must pay back in addition to the initial amount is the interest. When you deposit money in a bank, the amount the bank pays you to keep the money in that account is also called interest. This is because the bank is effectively borrowing money from you. The interest rate is normally determined as a percentage of the original sum. In this blog post, we want to cover the most typical interest rate types.
This is the most basic type of interest rate. It is paid one time and does not change. If you borrow 100 Euros from a bank for one year at a rate of 5%, after a year you owe the bank 105 Euros. If you deposit money to the bank for the annual interest of 5%, you effectively lend your money to the bank. When maturity term comes, the bank owes you 105 Euros.
Simple Interest calculation formula:
First year: 100 EUR x 1 year x 5% = 5 Eur in interest
Second year: 100 EUR x 1 year x 5% = 5 Eur in interest
Total Interest: 10 EUR
Total of the principal amount plus interest = 110 EUR
In this scenario, the total amount of interest paid over the life of the loan would be 10 Euros.
Compound rates charge interest on the principal and on previously earned interest. If you borrow 100 Euros at a rate of 10% for a term of two years, you’ll owe interest of 10 Euros at the end of the first year and 11 Euros, or interest on the first year’s total of 110 Euros, at the end of two years, bringing the total interest owed to 21 Euros. The same is true if you put a deposit in a bank with the same interest rate. This type of interest rates is often used for credit cards and savings accounts. We recommend reading a blog post on compound interest investing strategy.
Compound Interest calculation formula:
First year: 100 EUR x 1 year x 10% = 10 EUR in interest
Second year: 110 EUR (100 EUR principal plus 10 EUR accrued interest) x 1 year x 10% = 11 EUR in interest.
Total Interest: 11 Euros
Total of the principal amount plus interest = 111.00 Euros.
This is the type of interest typically used in home and car loans. The loan itself is divided into fixed payment amounts paid each month. The sum remains the same each month, but the ratio between the interest and the principle changes. In the beginning, the larger amount of payment goes for paying interest and smaller for the principle. Bit by bit, the amount of principal paid each time increases, thus reducing the principal and the amount of interest. The amount of interest on the principal shrinks over time despite the fact the interest rate stays the same.
Fixed interest rates stay the same over an agreed period. These rates are unaffected by market factors or change of general interest rates set by Central banks. Whether they increase or decrease, you pay the same, initially agreed on interest rates. It helps you to calculate the total amount you owe to the bank and have to pay back. This type of interest rates is usually used in the mortgage or long-term loans.
Variable interest rate changes depending on how much market base rate fluctuates. If basic market rates rise, the lender can accordingly increase lending rates and the borrower may not be able to repay them due to sharp increases in repayment amount. On the other hand, if the rates fall, the borrower will benefit from decreased repayment amounts. This type of loans is typically used in loans such as adjustable rate mortgages.
Prime interest rates are primarily used by banks at which they lend to their preferred or favorite customers, especially those that have excellent credit scores. Banks calculate and adjust this rate according to the federal funds rate, which is used inside banks for lending to and borrowing form each other.
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Disclaimer: It is important to point out that the approach presented here is not necessarily suitable for everyone and is presented for information purposes only. It is not intended to be investment advice. You should seek a duly licensed professional for investment advice matching your specific situation.