What is the interest rate?

Interest rate is a very common term that you must have heard a lot in the context of loans. Well, the percentage of principal amount that you are required to pay over a specific period of time as fee is referred to as interest rate. Before proceeding further, let us first try to have an understanding of the term interest. Interest is the amount that you pay as fee on the borrowed amount. Interest can be payable on any asset such as money and shares.

When you buy something for which you seek loan from one of the financial institutions, you are obliged to pay back not just the principal amount but also the interest amount calculated as a certain percentage of the total amount. It can be said that interest is the compensation for blocking the money of the bank for a long period of time. This loaned money could have been used for making other fruitful investments by the bank.

Interest rates are basically of two kinds namely simple interest rate and compound interest rate. Let us take simple interest and compound interest one by one.

Simple interest: This is a popular form of interest that is calculated on the principal amount using this formula:

For example if someone has taken a loan of R1,00,000 at the rate of 5% for a period of 5 years then

So, this is how simple interest is calculated.

In addition to it, there is another type of popular interest called compound interest. Let us try to find out what is it exactly?

Compound interest is almost the same as simple interest with some slight difference. The basic difference lies in the fact that unpaid interest keeps getting accumulated and is added to the balance that is due to be paid. When interest becomes due but you don’t pay it, then it does not become interest payable but it gets added to the balance due and becomes compound interest rather than simple interest.

When the loan seeker fails to make the payment of interest as well as the original sum on time, then debt is calculated in a different manner using a different formula which is given below:

Compound interest = P [(1 + r)n – 1]

Where P refers to the principal amount, r is the rate of compound interest and n is the term period. In case of compound interest, the total amount due is equivalent to the sum of principal amount and compound interest.

Coming back to interest rates, well, the rate of interest can be fixed or floating. Commercial loans are sometimes given on floating rates of interest in which the percentage can vary depending on the prevailing market conditions. Loans that are given at a constant rate of interest are known as fixed rate loans. It is also possible that loan may be given to you based on the combination of floating and fixed rate of interest.