Interest rate explained
Interest rate meaning
Interest rates represent the percentage that lenders charge borrowers on top of loans for everything from cash to cars to property. In its simplest form, it’s the cost of borrowing something.
However, these rates represent something else entirely from a saver’s perspective. If somebody has the ability to put cash away for a rainy day, interest rates reflect the reward that financial institutions will offer if their funds remain untouched.
Simple interest versus compound interest
There are several ways that interest can be calculated. Two of the most common are known as simple interest rates and compound interest rates.
Let’s say Lauren wants to buy a $10,000 car. A salesman offers her a loan where she can pay the cost off over four years in monthly instalments. The loan comes with a simple interest rate of 10%. This means she will be charged 10% of $10,000 on top of her repayments every year – resulting in a total cost of borrowing of $4,000 over the four-year agreement.
Compound interest rates can be incredibly expensive for borrowers, but they are great news for savers. Let’s imagine that Mary saves $10,000 for a year with an annual interest rate of 3%. At the end of those 12 months, her savings will have grown to $10,300. Because of compounding, she will then be able to earn interest on the whole $10,300 – not just the $10,000 she initially stowed away. By the end of year two, her nest egg would be worth $10,609 – an extra $9. Although this might not sound impressive to begin with, compound interest rates can add up over time. Over 25 years, she would have earned an extra $3,437.78 when compared with a simple interest rate.
How interest rates are calculated
Interest rates in countries around the world are normally set by central banks – the financial institutions that are responsible for printing money and managing the supply of a currency. The decisions they make can affect us all.
Borrowers and lenders will either pay (or receive) interest on a fixed or variable basis. A fixed interest rate means that it will be frozen for a set amount of time, while variable interest rates can fluctuate as central banks adjust their base rate. If this rate rises, homeowners could see their mortgage bills increase substantially. Meanwhile, a cut to the base rate could mean savers see less return on their savings.
Aside from what central banks decide, the amount of interest that a borrower pays can often depend on their financial history. From everyday consumers to businesses and national governments, lenders often look at credit ratings to see whether a borrower is “creditworthy” – or in other words, whether they are likely to pay back the loans they take out without difficulty. Reliable borrowers are normally rewarded with low interest rates because they are not regarded as risky, while those who have missed payments in the past usually end up with a high cost of borrowing.