The interest rates are the catchiest element of the finance industry. Every financial product is paired with some sort of interest rate, which decides its actual value. But with every product, same kind of interest rate cannot work. There are different types and they have a certain role to play. You should know about them, as you will find them unavoidable in every financial decision.
In every important decision, it is important to pay heed to the rate of interest. Whether you take a personal loan, home loan, or you invest money, it is going to play its vital role. Depending on the financial choice you make, the type of interest rate changes. You should know them and also how do they work.
As you can get the idea from the name, fixed rate is something that remains same. For instance, a loan with 5% interest rate will remain same throughout the tenure. There will be no impact of ups and downs on the market out there. If the loan amount is £10,000 then the borrower has to pay £10,500. This is the actual cost of the loan including principle as well as interest.
Again the name reveals everything. Yes, the type of interest rate that fluctuates and is prone to the changes of market conditions. The biggest factor that affects it is the prime interest rate. The finance companies base their interest rates on prime rates.
In these rates, the borrower gets the benefit if the rate goes low as the instalments become small. However, in case of rise in rates, the repayments may become big in size. There is a reason to apply variable interest rate. It prevents a situation where the borrower may pay less than the market value of a loan or credit.
The prime rate
As you read above, it is the decisive rate and affects the other types of interest rate too. For instance – the variable rate. Banks usually prefer to give prime rate to its favoured customers, as it normally remains low. The prime rate affects the rate of interest on all types of loans like auto loan, mortgage loan, personal loan. You can say, the prime rate is the decisive power that can affect the total cost of the loan in many types of loans.
Annual Equivalent Rate (AER)
This type of rate tells the amount that you will earn on your money in a year. However, it depends on whether you are paid on monthly basis or annual basis. The account that pays monthly will have a lesser return than the one with the annual return. However, the AER of both the account could be same.
Annual Percentage Rate
It is the annual rate on the total cost of the loan. Credit card companies and lenders use APR to set the interest rates. The way to calculate APR is quite simple. It is a total of prime rate + margin that the lender or bank charges from the consumer. Annual Percentage Rate is also prone to changes as prime rate factor works strongly here also. Lower the APR, cheaper is the deal. For instance the loan company such as British-lenders.uk , new horizons etc. are known for their low APR deals.
The discount rate
This type is not directly for the general public. It is actually the rate of interest that is used by a regulatory financial authority when it provides funds to finance companies. These companies take funds for varied reasons. To cover daily funding shortages, in any crisis, to correct liquidity issues. This helps the banks and financial institutions from failing.
Simple interest rate
The simple interest rate is used by the banks and lenders to calculate the rate of interest they take from the borrowers. It is basic in nature like APR, and formula to calculate the simple interest rate is –
Principal x interest rate x n = interest
Compound interest rate
Compound interest is used to calculate interest of a loan on an annual basis. The interest amount that comes is included in the loan balance. That same amount is used to calculate the interest payments of the next year on the loan. The CI is calculated on the two factors of principal and interest. Accountants also call it as ‘interest on interest’.
At the end, you can also categorise the interest rates in two categories. Earning interest and paying interest. Just as you can read above the AER and the APR. The first one tells you about the profit you earn while the other one tells about the amount you need to pay.
The above types are ubiquitous in their presence. Wherever you go all over the world, they are sure to appear with the financial products. The knowledge of the types on rates is always necessary to take smart, rational and sensible financial decisions.