Without the interest rates that come with loans, It wouldn’t be too odd to say that lenders wouldn’t be lending money to borrowers. Interest rates serve as a pat on the back of lenders for so many reasons. It serves as a consolation for the risk of giving their money to other people. Remember that they could have invested their money and made returns on their investments.
However, as you read along this article, you’ll know more about interest rates, how they work, and so on.
What is an Interest rate?
The interest rate is the amount a lender charges a borrower for using assets that is expressed as a percentage of the principal. They typically note the interest rate annually as the annual percentage rate (APR). Large assets such as vehicles or buildings, or cash and consumer goods can be borrowed assets. The interest rate is commonly referred to as the ‘lease rate’ in the case of larger assets.
The amount of risk associated with the borrower gets a proportional rate. The interest serves as compensation to the lender for giving the loan to a borrower. This is because the lender would have invested the money to yield money instead of giving it out to a borrower.
Lenders can place interest rates over different periods; such as monthly, quarterly, or bi-annually. However, most times they annualize interests. Besides that, interest rate can also be the rate a bank pays their clients for keeping deposits in the bank.
How do interest rates work?
You already know that interest rate is the charge a borrower requires from a lender for using his assets. Lease rates serve as the interest rate in the case of a large asset, such as a vehicle or building.
When the lender considers the borrower as low risk, the borrower will usually have lower interest. But if the lender considers the borrower as high risk, the borrower will charge the lender higher interest rate. This implies that lenders typically assess risk when they look at potential borrowers’ credit score. So it is essential you have an excellent credit score to qualify for good loans.
Most commonly for loans, they apply the interest to the principal, which is the amount of the loan. You can also see it as the cost of debt on the side of the borrower. Whereas it’s a return for the lender.
When do they apply interest rates?
Most lending and borrowing transactions usually bear interest.
In order to purchase homes, fund projects, pay tuition fees and so on are what individuals borrow money to do. Whereas businesses get loans to fund their capital projects and expand their business operations. They usually do this by purchasing fixed and long-term assets like land, buildings, and machinery. Thereafter they’ll repay the money they borrowed in a lump sum by a predetermined date or periodic installments.
So the money borrowers repay is usually more than the amount borrowed since lenders require compensation. This is because of their sacrifice for opting to lend their money instead of investing it during the loan period.
Case study of interest rate
In order to understand how interest rate works, a case study will help explain it better.
For example, if an individual takes out a GH₵300,000 mortgage from the bank. And the loan agreement stipulates that the rate on the loan is 15%. This means that the borrower will have to pay the bank the original loan amount of GH₵300,000 + (15% x GH₵300,000) = GH₵300,000 + GH₵45,000 = GH₵345,000.
Whereas, if a company secures a GH₵1.5 million loan from a lending institution that charges it 12%. Then the company must repay the principal GH₵1.5 million + (12% x GH₵1.5 million) = GH₵1.5 million + GH₵180,000 = GH₵1.68 million.
What are the kinds of interest rates?
There are kinds of interest rates and there are situations that could require any of them in a transaction. They include:
This rates protect the borrower from rising interest rates. The rate doesn’t change notwithstanding inflation in the market. But sometimes it could become worse for borrowers if the rate falls. For example, if the rate is 10% and the reference rate falls, the borrower must continue to pay the 10% instead of the lower rate.
- Variable-Rate (Floating)
This type of rate protects the borrower from falling interest rates. This is because they can easily adjust the loan rate. However, this type of loan is worse for the borrower. This is because it does not have a fixed rate of interest over the life of the loan. So you might end up paying way above what you paid initially depending on the current state of the economy (inflation).
What are the two types of interests?
There are types of interest that apply to loans. They are:
1. Simple interest
They calculate this type of interest on the original or principal amount of loan. You can calculate simple interest with the following formula:
Simple Interest = Principal × Interest Rate × Term of the Loan
For example, if the simple interest rate is 5% on a loan of GH₵1,000 for a duration of 4 years, the total simple interest will come out to be: 5% x GH₵1,000 x 4 = GH₵200.
2. Compound Interest
They calculate compound interest not just because of the principal amount. But also on the interest of previous periods that have accumulated. Because of this, they also call it “interest on interest.” You can calculate compound interest with the following formula:
Compound Interest = P(1 + i)n – P
P = Principal amount
i = Annual interest rate
n = Number of compounding periods per year
The compound interest will not be the same for all years just unlike simple interest. This is because it considers the accumulated interest of previous periods as well.
Note: The interest charged is the difference between the total repayment sum and the original loan. Then they apply the interest charged to the principal amount.
What are Real and Nominal Interest Rates?
A nominal interest rate does not have adjustments planned for inflation. Regardless of the rate of inflation that the economy faces. For example, the interest attached to a deposit will be the same even after several years.
Whereas the real interest rate considers the inflation rate. They measure the repayment of principal plus the interest because of real terms. Then compared against the buying power of the amount at the time they borrowed it.
It’s important to know the effects of inflation on purchasing power. This is because that’s the only way to know if you’re really earning a return from the interest. For example, if you deposit money with a lender (bank) and earn a nominal 2% annual interest. So, if the inflation rate is 4%, then in terms of purchasing power, the money you have on deposit will be actually losing 2% of its value every year.
The nominal interest rate minus the rate of inflation is the real rate of return on an interest-bearing account. So the rate stated is just the “nominal” rate. Which means “in name only” i.e. not the REAL rate being earned.
What are the factors that affect interest rates?
There are some factors that affect interest. They include:
- Forces of demand and supply
Demands for and supply of credit in an economy influence interest rates. The price of borrowing or rise in interest occur because of an increase in demand for credit.
Contrarily, when the supply of credit rises, it leads to a decline in interest rates. And the credit supply increases when the total amount of money that’s borrowed climbs.
For example, banks invest or lend out the money that individuals deposit in the banks. So as banks lend more money, there will always be more credit available, therefore, borrowing increases. Consequently, the cost of borrowing decreases as this occurs (just like the normal supply and demand economics).
The higher the inflation rate, will cause higher interest rate rise. Logically, the interest earned on money loaned must compensate for inflation. Lenders charge higher interest as compensation for a decline in the purchasing power of money that will be repaid.
The government’s monetary policy most times influences the amount of interest. Besides that, when the government buys more securities.
Banks have more money they use for lending, and because of this interest decrease. So, when the government sells these securities, money from the banks gets sapped. Thereby giving banks less money for lending, which will therefore lead to a rise in interest.
What is APR?
The APR is the acronym for Annual Percentage Rate (APR) which means the total cost of the loan. It comprises interest rates plus other costs. Also, the biggest cost is usually one time fees they call “points.” A percentage point of the loan is what the bank calculates them as. Brokers fees and closing costs are also what APR includes.
The APR and interest describe loan costs. The interest rate lets you know what you will pay per month. However, the APR goes further to tell you the total cost over the loan life.
What is the impact of high versus low-Interest rates?
There are impacts of both high and low interest rates on loans. Naturally, high-interest rates make loans more expensive. And when interest rates are high, there’ll be only fewer people and businesses that can afford to borrow. Consequently, it will lower the credit amount available to fund purchases which will slow down consumer demand. Because of this, many people will have to save as they have more in their savings rate.
Besides that, high-interest rates also reduce the capital to expand businesses and this strangles supply. And this reduction in liquidity surely slows down the economy.
The low-interest rates have the opposite effect of what high-interest rates have on the economy.
Lower housing prices have the same effect as low mortgage rates as they stimulate demand for real estate. However, low-interest rates can prompt inflation. Demand outstrips supply and prices usually rise if there is too much liquidity. This causes inflation.
Having read this article, before borrowing from any lender, ensure you carry out exhaustive research to know their interest rates. This is because failure to do so, you might get into more complicated financial problems than you were. Beside that, beware of loan sharks, who would always offer loans with hidden charges and unspecified interest rates. However, even after getting the loan, ensure you repay your loan completely according to your loan repayment terms. So that you’ll stand a better chance of getting another loan from your lender in the future. Especially should you find yourself in an emergency situation.