The interest rate was introduced as a tool that allows you to get paid for submitting your funds for other parties’ usage. Interest rates were introduced in Ancient Greece and sometimes were represented as natural goods, not money. For example, those who took grain had to return more grain.
In any case, throughout the years, the interest rate was assumed to be something negative, so banks and lending organizations, as we know them now, became widespread and completely legal in the recent past. Today, taking out a loan is quite easy, and almost everyone has taken out a loan, at least once, so it is important to know more about the essence of the interest rate, as well as the different types.
What Is Interest Rate?
The interest rate can be called payment for receiving a loan. When you take out a loan, you need to return the total loan amount, plus interest rate, which is derived from the amount owed. For example, if you take a $100 loan and a 7% interest rate, you need to return the $100 principal and $7 in interest.
It all comes down to interest rates. As an investor, all you're doing is putting up a lump-sum payment for future cash flow. Ray Dalio, billionaire investor, hedge fund manager, and philanthropist.
When Are Interest Rates Applied?
The interest rate is applied when you lend assets - fiat, crypto, etc. No matter whether you are an individual or act as an entity, the interest rate can be applied when you borrow funds. The interest rate can rise or decrease - it all depends on the terms of the loan.
How Is The Interest Rate Calculated?
There are different types of interest rates, and thus each type is calculated differently. Regardless of what interest rate amount is applied, it can always be represented in an equation. We will disclose below how to calculate simple and compound interest rates.
How to Calculate Simple Interest Rate
A simple interest rate is a basic type of interest rate. It considers that you need to repay a principal plus interest only. For example, when you take out a $100 loan, with a simple interest rate of 5% applied, you need to repay $105 in total.
However, usually, when you take out a loan, there is a specified term for which the interest rate is applied and payment periods. Usually, the interest rate is applied per annum, and the payment period is applied on a monthly basis. Thus, if you take $100 for three years, and a simple interest rate makes 5% per annum, you have to repay:
$100*(5%*3+100%) = $115
We take $100 as principal, multiply 3 by 5% as there are three years for the loan usage with a 5% interest rate per annum.
Your monthly payment will be:
We take the whole sum to repay, which totals $115, and divide it by the number of months in 3 years, which equals 36. Thus, you need to pay $3.19 if you take out a loan under the terms described above.
How to Calculate Compound Interest Rate
Compound interest is much more complicated than simple interest. An applied compound interest rate means that you pay interest on the principal, plus interest on the interest for the past time periods. In plain words, that means that if you take $100 for three years, with a 5% compound interest rate per annum, you will be charged by $5 interest for the first year, $5.25 for the second year, and $5.51 for the third year. The full interest amount will total $15.76, and the whole sum you need to repay will equal $115.75 ($100 of principal plus $15.76 in interest).
The compound interest you need to repay can be calculated using this formula:
CI=P*(1+IR)^n-P; CI - compound interest P - principal IR - interest rate
When you compare a simple and compound interest rate, it’s obvious that the second option is worse for the borrower if the same rate is applied. For example, we have provided the difference only equals $0.76 ($15,75-$15). However, if you take out a loan for a long period of time, like 20 years, the difference becomes much more significant.
Which Types of Interest Rates Are There?
Along with the simple and compound interest rates, there are other types of interest rates one should know about:
Fixed Interest Rates
A fixed interest rate considers that it won’t change no matter how the interest rate changes on the market. For example, if at the moment you take the loan at a 7%vinterest rate, with a medium interest rate on the market of 7%, it remains unchanged no matter what.
Most lenders prefer this type of rate because it allows you to plan your payments precisely. The main advantage of this kind of rate is stability. However, there are issues with it, as well. For example, your interest rate cannot be decreased if the interest rate on the market falls. On the other hand, it cannot rise if the interest rate on the market rises.
Variable Interest Rates
A variable interest rate means that the interest rate for the loan can change, and its size depends on the prescribed conditions. For now, in the US, the variable interest rate usually changes along with changes in the Cost of Savings Index. The good thing about this type of interest rate is that it can decrease. However, the bad thing is that it can increase as well, and thus you may have issues with repaying the loan. Generally, it is an antipode of the fixed interest rate.
Amortized Interest Rate
An amortized interest rate is about charging the principal remaining with the interest rate applied. Thus, an amortized interest rate considers that you pay more interest at the beginning of the loan period and less principal. As time passes, you pay less interest and more principal.
Prime Interest Rate
This kind of interest rate is usually applied to large institutions like banks or corporations. The prime interest rate is usually lower than the general interest rate and is only enforced for trustworthy parties.
Discount Interest Rate
A discount interest rate is applied for short term loans. It is calculated on the basis of the risks, borrower’s cash flow, and other temporary factors.
Comparison Rate for Decision-Making
When you have a choice of alternatives to choose from when taking a loan, your best helper in this decision making is the comparison rate. It is used to figure out the loan cost deriving the interest and all other costs that will be charged when you take the loan. For example, if the interest is 7%, while in the meantime, the fees and charges applied for this loan make 0.3%, the comparison rate will equal 7.3%. This indicator allows you to get a clear understanding of your true costs for loan repayment.
Thus, when you have several offers to take out a loan from, consider not only the interest rate but the comparison rate as well. Let’s take an example:
- One bank offers you a loan with an interest rate of 6%. Along with that, you are charged for loan insurance by 0.2% and a service fee of 0.6%.
- Another bank offers you a loan with an interest rate of 6.5%. There are no additional fees applied.
As you can see, although the first bank offers you a loan for 6%, your comparison rate will make 6.8%. Although the second bank offers a greater interest rate for the loan, it is still going to be a more profitable solution to take out a loan there as 6.8% is more than 6.5%.
What Is The APR
APR is the annual percentage rate. The annual percentage rate is a coefficient of the rate which is charged per annum. The APR is the basic and most widespread indicator used to evaluate the cost of the loan. Considering the APR is vital for decision-making purposes.
What Is the Difference Between Interest Rate and APR
There is actually no difference between the interest rate and APR. Actually, APR is one of the characteristics of the interest rate. As we already know, APR is the annual percentage rate, which means that it is the charge for the loan per annum. The interest rate is a figure that shows the charge for using the loan. Usually, when someone points out the interest rate, the period for which it is applied, is also underlined. For example, what we call interest rate can be applied per quarter or on a monthly basis. Though usually interest rate is applied per annum, so in the majority of cases, the interest rate equals the APR.
Let’s take an example. You take out a loan with an interest rate of 4% per quarter applied. If it is a simple interest rate, then you can say that the APR for this loan equals 16% as there are four quarters in a year.
Interest Rates and the Forex Market
Interest rates play a large role in the economics and financial markets, including Forex. The increase of interest rate usually considers that the economy has slowed down, while a decrease in the interest rate usually means that the economy is moving faster.
Depending on the assets and tools Forex traders deal with, there can be different effects upon a change of interest rate, on the global markets. An inadequate interest rate, no matter whether it is too low or too high, will cause instability and crises on the market, which should be considered by the Forex trader when one figures out a strategy.
How Do Interest Rates Affect Currencies?
The higher the interest rate, the higher the inflation will be. If you compare prices 20 years ago and today, it will be obvious that they have increased dramatically. That is all tied to inflation, so $10 today and $10 in the 1990s is a lot different.
If the central bank of a specified country has increased an interest rate, this will lead to the growth of inflation of the currency, and in the long or even short term, this factor will cause a falling trend for the specified currency.
Thus, for a trader, it will be valuable to have practice dealing with this factor. Track the changes in the currency price on the Forex after the release of news related to a change in interest rates.
Forex traders should be aware of interest rates, types of interest rates, policies of central banks, and other related subjects. The thing is, prediction of changes in interest rates in a given period can help a trader make better decisions.
Knowledge of interest rates on the mortgage or business loan markets and peculiarities of this subject will also be helpful. Considering the role interest rates play in the global economy and all of the industries, a trader who ignores this topic will be blind in one eye.
To figure out the best strategies for using information about interest rate changes in trading, use the Libertex trading platform. Here you can open a demo account and test various strategies to examine them for efficiency.
Consider registering an account and making demo orders upon receiving a change of interest rate news release. For example, try the EUR/JPY trading pair. Track the changes in interest rates of central banks and news related to this topic, and make orders (long or short) based on these changes. It is likely that, based on monitoring the interest rate, you will build a successful trading strategy on the Forex market.
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