Types of Interest
Interest is one component of debt that makes the whole thing a lot scarier. At the same time, loans would not be so profitable without them. As with anything in economics and finance, there are many types of interest. Keep in mind, we are not talking about types of interest and hobbies, or types of interest of a person, or types of interest groups. We are looking at interests in finance and economics.
- Definition and Types of Interest in Economics
- Other Types of Interest
- Types of Interest Income – Saving Accounts
- Importance of Interests
Definition and Types of Interest in Economics
Let’s go back to the basics. What is interest? It is a monetary charge for borrowing money. Normally, this comes as APR or annual percentage rate. That means, interest is expressed as a percentage, taken from the amount owed. The interest is the amount of cash the lender gets for lending out their money. Sometimes, interest may refer to the stockholder’s ownership amount in a company.
There are two main types of interest in life: simple and compound. You also find these two types of interest in maths.
Simple interest looks at the original amount lent and multiply it by the rate. That means, you have to pay the same in interest no matter how much you pay to clear the debt. For example, suppose that you borrowed $1,000 at a 1% interest rate every month. That means, you have to pay $10 every month in interest alone. If not, your debt goes up to $1,010 the next month, and $1,020 the second month, and so on. If you pay $100 the first month and $10 in interest, your debt would go down to $900, but your interest remains at $10, not $9. The interest is decided on the principal or original amount of money lent, so it remains the same no matter how large or small the debt is.
On the other hand, we have compound interest. You see this the most often despite it being slightly more complicated. The amount you pay in interest takes into consideration both the principal and interest on the loan. In other words, you are paying for both the interest in the principle and the interest itself. Using the same example above, your debt would go up to $1,010 the first month. However, in the second month, it goes up to $1,020.10. The third month, $1,030.30.
This is because in the first month, your debt is $1,000 and the interest rate is 1%, so $10. After that, your debt goes up to $1,010. For the second month, the compound interest takes into calculation the new amount owed, which is $1,010. So, 1% of that is $10.1. Add that to $1,010 and you get $1,020.10. The third month comes around, and the rate applies to $1,020.10. $1 of that is $10.201. Add that to $1,020.10 and you get $1,030.301, and we round that down to $1,030.30.
Of course, calculating both types of interest may seem easy if you do it month-by-month. But if you want to see how much debt you would accrue over the year or even longer, things can get tricky. Luckily, you do not have to do the math yourself. You can use a free online calculator such as CalculatorSoup for both simple and compound interest. They also provide various types of interest formula so you know how they come up with these numbers.
Compound interest is more popular because it provides better benefits over time. The complexity of interest comes in when you consider the frequency of compounding. Just because you get 10% interest every year does not make it a better deal than 5% interest semi-annually. You might not notice the difference between the rate the first few times, but over a longer period and you will feel the effect. The interest on interest can create higher and higher returns the longer you leave it there. This is what people call the miracle of compound interest.
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Other Types of Interest
If you look deeper into the world of interest, you can see that there are many other types of interest. If you are on the paying side of the debt, it is in your best interest to understand how they work. That way, you can get a better deal next time you apply for a loan.
The first you may hear is “fixed interest”. This is basically simple interest, just worded differently. In principle, both are the same. People may use this wording because it is easier to understand.
Prime interest rate is basically the interest rate offered to certain customers. This rate is lower than the rate offered to other customers. Banks usually use prime interest rates when borrowing and lending money to other banks.
Variable interest rate is interesting because it allows the interest rate to change depending on the circumstances. Variable interest changes depending on the movement of base interest rates, or prime interest rates. As you might suspect, this can be both a blessing and a curse for the borrower. Sometimes, they end up paying less with variable rates and the prime interest rate goes down.
However, if the base interest rate goes up, then the borrower may have to pay more interest rates. Banks use this strategy to prevent the interest rate from going so far to the point that the borrower ends up paying less than the market value on a credit or loan.
APR or annual percentage rate is the total amount of interest annually. You see this with credit card companies when they issue a balance on their credit card account. APR follows a simple formula. It is the prime rate plus the margin from the lender or bank.
Finally, we have the discount rate. Think of this as a prime rate, except it is usually between the government and financial institutions. The U.S. Federal Reserve lends money with a discount rate to banks or other institutions for a short time. Banks borrow money from the government for a wide variety of reasons. That includes covering daily financial shortages to prevent bankruptcy.
You may also hear about amortized rates. These are common in home or car loans. They are set up in a way that borrowers pay a large amount in interest and a smaller amount in principal at the beginning of the loan. As time goes on, the amount goes into paying the principal. In doing so, the principal amount decreases and so does the interest. In the end, the interest on the principal goes down as you continue to pay while the interest rate remains the same.
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Types of Interest Income – Saving Accounts
Many people have a savings account, but very few fully understand how it works. So far, we only talked about how interest would look like for you as a borrower. With a savings account, you flip the script. This time, you are the lender, and the bank with which you open your saving account is the borrower.
Interests on a savings account are basically the money you get from your bank or financial institution. In a sense, you are lending your money to your bank so they can fund other customers. In return, you get paid in the form of interest. As you might expect, the interest rate on a saving account is lower than the interest of loans from the same bank.
Savings accounts usually use compound interest, so you end up earning a lot more money over time. However, since the interest rate is very low, many people decide to just leave the money there. This is good since the amount compounds over time. In fact, you can see how Benjamin Franklin did it to demonstrate the snowballing effect in compounding interest.
What you need to understand is that for the effect to be felt, you must not withdraw any money from it unless it is absolutely necessary. In accounts with simple interest, people can just take out the amount paid in interest, therefore turning into a passive source of income.
With compound interest, you need to let it grow. Sometimes, you may have an option to go for more frequent compounding (daily, monthly, quarterly, etc.) at the cost of a lower interest rate. As mentioned before, it might be a better idea to go for more frequent compounding at a lower interest rate since your savings will grow faster.
Even so, you may see that the amount you earn after each compounding to be minuscule. But the idea is that you need to do more than just leave some money there and forget it. Consider setting aside some money add put it into the savings account. You are building up that reserve funds for a rainy day. You will not see how much money you suddenly have until years later. But, you will be glad that you did ten years from now when you see that your savings have increased tenfold with just a small contribution every month.
Importance of Interests
Understanding the types of interest you are dealing with can help you secure better deals in the future. The percentage and the money from the interest may be small at a glance, but they can snowball into huge sums given enough time.
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