Interest is the monetary reward to a creditor or financial institution for borrowing money. Interest is the amount of money given for the opportunity to borrow money (annual percentage rate - APR) or a shareholder's participation percentage in a company.
When choosing an investment strategy, it is necessary to consider that there are 2 types of interest income.
Simple interest is a method of calculating interest, in which payments are made on the initial amount of investment. For example, an investor bought $200,000 in bonds with a 15% annual coupon. After 12 months, if the market value of the securities is the same, he can sell them for $200,000, earning $30,000 in interest.
Compound interest is a method of calculating the investment profitability that takes into account the income from interest paid over the previous period. For example, an investor does not leave bond coupon amounts lying on his account, but reinvests in securities. Thus, the amount invested regularly increases, and in the next period, interest is paid on the increased amount. This is called interest capitalization.
When calculating the type of interest and the amount the creditor collects from the borrower, the following factors are taken into consideration:
- Inability cost (the creditor is not able to use the money he or she leant out).
- Inflation value.
- Default (risk of inability to pay the loan back).
- Loan term.
- Interest rates (government intervention).
- Loan liquidity.
Important note: APR covers the loan's interest rate and other payments (for example activation fees, decommissioning costs or discount points).
Types of Interest rates
There are different interest rate types. In November 2020, the USA had 4.22% average rates for auto credit, 3.22% average fixed rate for mortgages and 16.03% average interest rate of credit cards (depending on card type and credit score).
Important note: Personal credit score is the most important indicator for creditors to offer different loans with different interest rates.
There is a subprime market of credit cards for people with a bad credit score. It offers interest rates as high as 25% and higher fees for credit cards, but it gives an opportunity to improve credit scores.
History of Interest rates
Interest is an ancient practice, but for the ancient civilizations of the Middle East before the Middle Ages, charging interest on loans was considered unacceptable by social norms. Loans were taken by people in need and there was no product other than money, so taking interest was almost a sin.
To charge interest for borrowing money became commonly accepted only with the Renaissance. People began borrowing money to grow their businesses trying to improve their situation. Markets were growing and the economy was mobile, so borrowing became more common and interest charges more acceptable. Money began to be seen as a product, and payment for loaning money, began to be considered a decent payment rather than a sin and a disgrace.
Islamic countries use a completely interest-free banking system (in Iran) or apply partial measures (in Sudan and Pakistan). In these countries, creditors do not charge interest on loans, but participate in profit and loss sharing. This system of banking became common by the end of the 20th century. It does not depend on the rate of return.
Nowadays, interest rates can be applied to different financial products, including mortgages, credit cards, car and personal loans. Interest rates began falling in 2019 and were reduced to almost 0% in 2020.
Basic idea of Interest rates
When the Federal Reserve lowers interest rates, it stimulates economic growth, it becomes cheaper to borrow money. This benefits buyers and banks alike. New home buyers have a lower monthly payment. The expenses go down, and the consumers have more money left over. This money can be spent on other needs and more major purchases can be made. Banks have an opportunity to lend more money.
On the other hand, high interest rates send a message that the economy is strong and well-developing. When interest rates are low, investment and savings account profitability is low. Because of this, debt increases, which creates a high probability of default when rates rise.