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HomeBusiness TipsTop 7 Types of Interest Rates Explained with Examples

Top 7 Types of Interest Rates Explained with Examples

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Interest rates are the cost of borrowing money, expressed as a percentage of the principal loan amount. They play a significant role in the economy, influencing consumer spending, business investments, and government policies.

Introduction

Interest is crucial to how money moves in the financial industry, acting as the “grease” that gets the lending and credit trains moving. Simply put, interest is the additional payment made to a lender for the privilege of borrowing money. 

The interest may be a fixed amount of money (fixed rate) or paid on a sliding scale (referred to as a variable payment). Interest rates are expressed as an annual percentage rate. 

In summary, interest is the fee you must pay to use credit. It has a set cost and is charged over a predetermined time frame.

Do you know? Historians believe that the concept of interest emerged from the leasing of animals or crops for productive purposes and was established in 3000 BC.


Types of Interest Rates

Here is a list of the different types of interest and how each may affect someone looking for credit or a loan. 

Take a look.

1. Fixed Interest Rate

The most common type of interest rate assessed to the loan borrower by lenders is a fixed interest rate. The interest rate is fixed for the duration of the loan’s payback period, as the name implies. 

When the loan is approved, it is often decided by mutual consent between the lender and the borrower. 

Calculations for this are simple and easy to understand.

  • It makes the precise amount of the interest rate obligation linked with the loan known to both the lender and the borrower.
  • Fixed interest rates do not change over time or during the loan term. This provides the borrower with an accurate estimate of future payments.
  • Although a fixed interest rate has the potential to be higher than variable interest rates, this eventually eliminates the chance that a loan or mortgage may become prohibitively expensive.

Example

A borrower with a fixed interest rate is someone who obtained a home loan from a bank or other lender for ₹100,000 at a 10% interest rate. This is for a 15-year term. As a result, the borrower will pay interest on a 15-year loan for a total of 10% of ₹100,000, or ₹10,000, per year. 

This means that he must pay ₹10,000 over the course of 15 years, with the principal amount increasing annually. As a result, neither the interest rate nor the amount of interest the borrower must pay the bank has changed. 

It becomes more accessible for the borrower to make the payment and organise his budget correctly.

Read More: What are the Important Traits of a Successful Entrepreneur?

2. Variable Interest Rate

The opposite of a fixed interest rate is a variable interest rate. In this case, the interest rate changes over time. 

The movement of the base interest rate, also known as the prime interest rate, is typically correlated with the movement of variable-rate interest. The borrowers benefit if the loan has a variable interest rate and the prime lending rate decreases.

The borrowing rate also decreases in this situation. This typically occurs when the economy is in crisis. 

On the other hand, the borrower is compelled to pay a higher interest rate in such circumstances if the base interest rate or the prime interest rate increases. 

Banks will consciously take this action to protect themselves against low interest rates that the borrower is forced to make payments significantly less than the market interest rate on the loan or debt. 

Similarly, the borrower gains an additional benefit when the prime interest rate decreases after a loan is issued. With the variable rate linked to the prime interest rate, the borrower need not overpay for the loan.

Example

Let’s say the borrower gets granted a home loan with a 15-year repayment period for ₹100,000 at a 10% interest rate. According to the agreement, the borrower must pay an interest rate fixed at 10% for the first five years or ₹10000 years, and then it changes and is determined by the prime interest rate or base rate after that. 

Let’s say the prime rate rises five years from now, increasing the borrowing rate to 11%. As a result, the borrower currently pays ₹11,000 annually. However, if the prime rate decreases and the borrowing rate is reduced to 9%, the borrower would save money and only pay ₹9,000 annually.

3. Annual Percentage Rate

In credit card firms and credit card payment methods, annual percentage rates are used frequently. Here, the outstanding interest amount is divided by the entire loan cost to determine the annual interest rate.

Credit card companies use this strategy when customers carry a balance forward rather than paying it off in full. The prime interest rate, which is calculated as the annual percentage rate, is also multiplied by the margin the bank or lender assesses.

Example

Let’s say we have a credit card with a 24% APR. It implies that we will be taxed 2% monthly for 12 months. 

Since not all months will have precisely the same number of days, the APR is further divided by 365 days, or 0.065%, to obtain the DPR. 

The daily percentage rate, or DPR, is the product of the daily rate and the daily card balance. After that, the number of days in the payment period is multiplied by this result.

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4. Prime Interest Rate

Banks often offer the prime interest rate to their most valued clients or clients with excellent credit histories. This rate is generally cheaper than the standard lending/borrowing rate. 

It usually has a relationship with the loan rate set by the Federal Reserve. This is the rate at which different banks lend and borrow. However, not all clients will be able to choose this loan.

Example

If a large firm has a history of consistent borrowing and excellent payback, and the bank approaches the lender for a short-term loan, it can get the loan at a prime rate and provide it to the client as a friendly gesture.

5. Discounted Interest Rate

The general population is not affected by this interest rate. This rate is typically used when Federal Banks lend money to other financial institutions for short periods of time, sometimes just one day. 

Banks may choose to take out these loans at a reduced rate to mask their lending capacity. This is to address liquidity issues or avoid collapse during a crisis.

Example

Consider the case where a bank contacts the Federal Bank to ask for loans at a reduced rate to replenish their liquidity or lending status for the day when loans or lending surpass deposits in a single day.

6. Simple Interest Rate

Simple interest is the rate of interest a bank charges its clients. Basic calculations typically involve multiplying the principal, interest rate, and number of periods.

Example

The simple interest calculation is ₹1000 x 10% x 3 = ₹300 if a bank charges a 10% interest rate on a loan for ₹1,000 for three years.

7. Compound Interest Rate

Interest on interest is another name for the compound interest approach. Banks typically use the calculation to determine bank rates. It depends on two key factors: the principal sum and the loan’s interest rate. 

Here, banks will first apply the interest amount to the loan balance, and any outstanding balances will utilise the same amount to determine the interest payment for the following year.

Example

As an illustration, we made a ₹1,000 investment at 10% interest in a bank. We will earn ₹100 in the first year. In the second year, instead of using ₹10,000 to determine the interest rate, we will use ₹10,000 plus ₹100, or ₹10,100. 

As a result, we will make more money than under a simple interest structure.

Conclusion

Understanding interest rates and their operation is essential to maximising loan and investment opportunities. Additionally, a comprehensible understanding of interest rates assists businesses in operating their financing options, measuring project viability, and efficiently directing risks. 

The information on interest rates empowers folks and businesses to navigate the multifaceted financial landscape with superior buoyancy and make resonance financial decisions.

One day, you may need to make a significant decision about one of them—with your money on the line. So, save this article and use this well-researched information to make investments. 

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