The interest rate is the payment of the borrower to the lender equal to a percent of the loan's principal. It is set on an annualized basis and is called the APR (annual percentage rate).
Also, the interest rate is applicable for deposit accounts. The APY (annual percentage yield) relates to the interest earned on CDs (certificates of deposit), deposit accounts in a bank, credit union.
Understanding Interest Rates
Interest is a payment for the use of an asset. A creditor may provide the borrower with money, vehicles, property, and consumer goods, which are borrowed assets.
Almost all lending or borrowing transactions come with interest rates. People borrow money to buy housing, start or maintain businesses, pay for education, and finance projects. Businesses take loans to acquire fixed and long-term assets (equipment, buildings, land) to expand their activities, to finance capital projects. The money borrowed is repaid either in a full amount by a predetermined date or in periodic payments.
In credit, the interest rate refers to the loan amount (principal). The interest rate is the rate of profit for the lender and the price of debt for the borrower. The loss of money used during the lending period must be compensated, so the refund amount is greater than the loan amount. For example, instead of borrowing, the lender could invest the money and earn a return on the asset. Interest equals the total repayment amount minus the initial loan.
To determine a borrower's risk group, it is necessary to look at his/her credit history. The better the credit history, the better chance of getting a good loan. A low-risk borrower is more probable to get loans with an interest rate lower than a high-risk borrower, whose interest rate would be higher, resulting in increased loan costs.
Simple Interest Rate example
If you get $100,000 credit from the bank and the loan agreement sets a 4% interest rate, so you will have to pay the bank the loan amount of $100,000 + (4% x $100,000) = $100,000 + $4,000 = $104,000, where $4000 is 4% annual interest payment.
The formula for annual simple interest:
If the loan term is 30 years, the interest payments would be:
After 30 years, the borrower will have to pay $4,000 x 30 years = $120,000 in interest payments. This is the way of making money for banks.
Compound Interest Rate example
Using the same data, at the end of 30 years, the total owed in interest is almost $200,000 on a $100,000 loan with a 4% interest rate.
The formula for 30-years compound interest:
Compound interest is an interest on interest. It means a higher percentage of payments. Compound interest is calculated both on the principal and on accumulated interest from previous periods. The bank expects the borrower to pay the principal adding interest at the end of the year. Also, to pay at the end of the 2nd year the principal adding interest for the 1st year and interest on interest for the 1st year.
Compounding interest is calculated monthly on the principal and interest accumulated for the previous months. For short loan terms, the interest calculation method will be similar. But the longer the loan term, the greater the difference between the two types of interest calculation.
Borrower's cost of debt
Interest rates are the lender's income and the borrower's cost of debt. Companies compare the cost of borrowing and the cost of equity (e.g., by paying dividends) to determine which financing source would be more profitable. They estimate the cost of capital because companies finance their capital by borrowing money and/or issuing stock. This helps to find an optimal capital structure.
How are Interest Rates determined
Banks' interest rates are affected by several factors (e.g., the state of the economy, inflation). The range of APRs offered by a bank depends on inflation and the interest rate set by the FRS (in the U.S.) or the central bank (other countries). The higher the FRS or CB interest rates, the higher the cost of debt. People begin to avoid credit and consumer demand decreases.
High interest rates force people to save their money (the savings rate gives a higher income). The stock market suffers from this (investors choose high savings rates rather than investing in a stock market with lower profitability). Businesses cannot obtain debt financing, which leads to an economic downturn.
Low interest rates encourage borrowers to take credits, which stimulates the economy. Businesses and individuals are interested in buying stocks (risky investment instruments). Such spending helps to stimulate capital markets and economic growth. Government instruments try to put low interest rates, but this leads to an imbalance on the market (demand is greater than supply, this causes inflation). In case of inflation formation, interest rates go up. Sometimes this is related to Walras’ law. In these cases, Banks have tools to fight against inflation (high reserve requirements, tight money supply, or increased demand for credit).
In June 2021, the average interest rate on a long-term fixed-rate mortgage was 2.89%. The FRS does not change the amount of mortgage spending. Due to this, mortgage rates are kept at the same low level.
Interest Rates and discrimination
The U.S. has the ECOA (Equal Credit Opportunity Act). It prohibits discrimination in lending, but the system racism still exists. According to July 2020 data, mortgages for residents of white communities have lower rates than for residents of black communities. According to an analysis of 2018-2019 mortgage lending data, a bank could earn about $10,000 in interest for a standard 30-year fixed-rate loan.
The CFPB (Consumer Financial Protection Bureau) provides ECOA compliance. In July 2020, the CFPB publicly asked people to give feedback and comments in order to improve ECOA in lending sphere. Bureau Director Kathleen L. Kraninger called on the CFPB to back up its protection standards for any minorities with actions, and lenders to follow the law.