FINANCIAL MARKET

INTEREST RATES
INTEREST RATES

• The interest rate is the amount a lender charges for the use of assets
expressed as a percentage of the principal. The interest rate is typically
noted on an annual basis known as the annual percentage rate (APR).
The assets borrowed could include cash, consumer goods, or large
assets such as a vehicle or building.
TYPES OF INTEREST RATES
1. FIXED INTEREST RATE

• A fixed interest rate is as exactly as it sounds - a specific, fixed interest

tied to a loan or a line of credit that must be repaid, along with the
principal. A fixed rate is the most common form of interest for
consumers, as they are easy to calculate, easy to understand, and stable
- both the borrower and the lender know exactly what interest rate
obligations are tied to a loan or credit account.
• For example, consider a loan of $10,000 from a bank to a borrower.
Given a fixed interest rate of 5%, the actual cost of the loan, with
principal and interest combined, is $10,500.

• This is the amount that must be paid back by the borrower.

2. Variable Interest

• Interest rates can fluctuate, too, and that's exactly what can happen
with variable interest rates.

• Variable interest is usually tied to the ongoing movement of base

interest rates (like the so-called "prime interest rate" that lenders use to
set their interest rates.) Borrowers can benefit if a loan is set up using
variable rates, and the prime interest rate declines (usually in tougher
economic times.)
• That said, if base interest rates rise, then the variable rate loan
borrower may be forced to pay more interest, as loan interest rates rise
when they're tied to the prime interest rate.
• Banks do this to protect themselves from interest rates getting too out
of whack, to the point where the borrower may be paying less than the
market value for interest on a loan or credit.
• Conversely, borrowers gain an advantage, too. If the prime rate goes
down after they're approved for credit or a loan, they won't have to
overpay for a loan with a variable rate that's tied to the prime interest
rate.
3. Annual Percentage Rate (APR)

• The annual percentage rate is the amount of your total interest

expressed annually on the total cost of the loan. Credit card companies
often use APR to set interest rates when consumers agree to carry a
balance on their credit card account.
• APR is calculated fairly simply - it's the prime rate plus the margin the
bank or lender charges the consumer. The result is the annual
percentage rate.
4. The Prime Rate

• The prime rate is the interest that banks often give favored customers for
loans, as it tends to be relatively lower than the usual interest rate offered
to customers. The prime rate is tied to the U.S. federal funds rate, i.e.,
the rate banks turn to when borrowing and lending cash to each other.
• Even though Main Street Americans don't usually get the prime interest
rate deal when they borrow for a mortgage loan, auto loan, or personal
loan, the rates banks do charge for those loans are tied to the prime rate.
5. The Discount Rate

• The discount rate is usually walled off from the general public - it's the
interest rate the U.S. Federal Reserve uses to lend money to financial
institutions for short-term periods (even as short as one day or
overnight.)

• Banks lean on the discount rate to cover daily funding shortages, to

correct liquidity issues, or in a genuine crisis, keep a bank from
failing.
6. Simple Interest

• The term simple interest is a rate banks commonly use to calculate the
interest rate they charge borrowers (compound interest is the other
common form of interest rate calculation used by lenders.)
• Like APR, the calculation for simple interest is basic in structure. Here's
the calculus banks use when determining simple interest:

• Principal x interest rate x n = interest

• For example, let's say you deposited $5,000 into a
money market account that paid a 1.5% for three
years. Consequently, the interest the bank saver would
earn over the three- year period would be $450 < x .03
x 3 = $450.>
 7. Compound Interest
• Banks often use compound interest to calculate bank rates. In
essence, compound rates are calculated on the two key components
of a loan - principal and interest.

• With compound interest, the loan interest is calculated on an annual

basis. Lenders include that interest amount to the loan balance, and
use that amount in calculating the next year's interest payments on a
loan, or what accountants call "interest on the interest" of a loan or
credit account balance.
• Use this calculus to determine the compound
interest going forward:
• Here's how you would calculate compound
interest:
• Principal times interest equals interest for the first
year of a loan.
• Principal plus interest earned equals the interest for
the second year of a loan.
• Principal plus interest earned times interest equal
interest for year three.
The key difference between simple interest
and compound interest is time.
• Let's say you invested $10,000 at 4% interest in a bank money
market account. After your first year, you'll earn $400 based on
the simple interest calculation model. At the end of the second
year, you'll also earn $400 on the investment, and so on and so
on.
• With compound interest, you'll also earn the $400 you receive
after the first year - the same as you would under the simple
interest model. But after that, the rate of interest earned rises on
a year-to-year basis.
• For example, using the same $10,000 invested at a 4%
return rate, you earn $400 the first year, giving you a
total account value of $10,400. Total interest going
forward for the second year isn't based on the original
$10,000, now it's based on the total value of the account
- or $10,400.
• Each year, the 4% interest kicks in on the added
principal and grows on a compound basis, year after
year after year. That gives you more bang for your
investment buck than if the investment was calculated
using simple interest.