Interest Rate: The Percentage On The Borrowed Money

What Is an Interest Rate and How Does It Work ?

An interest rate in mathematics helps in determining how high the cost of borrowing is. It also helps in determining how high the value of rewards for saving in banks or any institution is. For example, if an individual is a borrower, the rate of interest is the amount charged for borrowing money from the banks or other private institutions.

In countries like the United Kingdom, the single most important interest rate is known as Bank Rate. The monetary policy report helps in determining whether or not the rate of interest is to be changed or modified. The rate of interest of banks influences numerous other aspects of the economy of the country. The rise in the rate of interest leads to more expensive money borrowing techniques as well.

There are two major ways in which the rate of interest can be calculated and they are simple interest and compound interest. For example, if a person borrows £130,000 from the bank at an interest of 2.5 % per year. Then the monthly repayment, in that case, shall be £583. However, an increment in the rate of interest by 1 % shall increase the monthly repayment as well and make it £651. This gets expensive for the borrower as well.

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How Are Interest Rates Determined ?

As interest is mainly calculated while dealing with monetary transactions, the rate is determined with the help of banking authorities. The central banks and banking authorities of the nation helps in determining the rate of interest for the banks. This is inclusive of the compound and simple interests both. Open marketing operations help in determining this rate of interest to a certain extent.  

Various factors help in determining the interest rates of the banking and financial sectors. The first one among them is the credit score. The higher the credit score is, the lower is the rate of interest. Credit history is the next most important determinant as the credit history helps in gathering information regarding the moneylender. The other determinants of interest rate are income and employment types, size of the loan that has been taken, length of term that has been considered, payment frequency, property types, co-borrowers and debit ratio as well.

Several other factors can affect the rate of interest. They are inclusive of the following- Escrow Preference, Closing Date, Occupancy Type, Residency, Available Assets, Asset Seasoning, Housing Ratio, Seller Contributions, Combined Loan-to-Value (CLTV) and a few others. All these in combination helps in the determination of the interest rate.

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How Do You Calculate Interest on Borrowed Money ?

The monetary amount which is borrowed from the banks is considered to be the loan amount. There are two major ways in which interest rates can be calculated they are simple interest and compound interests. Interest rates are one common rate that allows money lenders, banks and credit card issuers can make profits.

A simple rate can be calculated by the means of a formula that is:

Principal loan amount x Interest rate x Time (aka Number of years in term) = Interest

For example, if an individual takes a loan amount of $20,000 for 5 years at a rate of 5 per cent per annum, then as per the formula of Simple Interest, the interest is

$20,000 x .05 x 5 = $5,000.

Another interest that is calculated is the compound interest. The following formula helps in determining the compound interest in an amount.

 A = P (1 + r/n) ^(nt),

Here,

‘A’ stands for the final amount

‘r’ stands for rate

P stands for the initial principle

‘t’ stands for the number of periods elapsed

And n stands for the number of times interest applied per period

How Does Borrowing Money Affect Interest Rates ?

Whenever a person borrows money, it is often noticed that when the money is returned, the original value of it has gone down. The reason for this is simple, the increase in prices of goods and services. As a result of this, the purchasing power of money goes down. To remedy this, interest is charged so that the loss of purchasing power of the money is made up by the additional amount. The rate of interest depends upon several factors like availability of loans, inflation rate and soon.

All of these makes borrowing much more expensive if the rate of interest rises and similarly, borrowing money would be cheaper if the rate of interest is less. The rate of interest also depends upon the demand for borrowing. Whenever there is a high demand for borrowing money, the interest rate would be high because there is a greater chance of profit for the lender. On the other hand, if the demand for loans is less, then the lender may lower the rate of interest to part ways with their money quickly by attracting borrowers at lower rates. This entire scenario is created due to specific economic times and this is how interest rates are affected by borrowing money.

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What Are Interest Rates Expressed as a Percentage Of ?

The rate of interest is expressed as the annual percentage of the total amount borrowed, which is otherwise known as the principle. It is the charge that is imposed on the borrower by the lenders. The interest rate is calculated on an annual basis and is also known as the Annual Percentage Rate (APR). APR is often represented or expressed as a percentage that helps in determining the actual yearly cost of the funds over a term of the loan or the income of an individual on an investment.

This is inclusive of the additional costs or fees of transactions which is associated with the fund. APR helps in providing the consumers with a bottom-line number which the consumers can compare with loan providers, credit cards, and lenders. The financial institution needs to disclose the APR of the financial instruments before signing the instruments. APR helps in providing consistency while presenting an annual rate of interest and helps the consumers from misleading advertisements and information.