What are Interest Rates?
One of the most challenging things to understand about money is its ability to change over time. Unless you’re the kind of person who keeps all your cash in a suitcase underneath your bed, you’ve probably noticed how loans and investments have a tendency to grow and shrink when you’re not paying attention. A lot of interest can turn your most meagre investments into financial powerhouses and your tiniest bills into overwhelming black holes of debt. But how are these different levels of interest determined? What do we mean when we talk about interest rates? And how does this whole system really work?
Interest rates let you know how much interest you’re going to be paying on a loan or the amount of interest that you’ll be receiving from an investment. They indicate the percentage of the principal (the original sum of money) that is owed to the lender as payment for use of their assets per period.
In other words, the interest rate of a loan lets you know exactly what percentage of the original loan amount will be charged as interest when you repay your debts. If you’re still a bit fuzzy on the details, that’s ok. Let’s break it down further and really get to the crux of the matter. Obviously, there are many different factors that influence the size and value of your funds, but perhaps the most important one to consider is percentage interest.
Interest Rates – Simplified
People or institutions that lend out money can’t just expect the exact same amount back at the end of the day. If that was the case, they wouldn’t make any money at all. Instead, they need their clients to pay more money back so that they can make a profit. This is where the concept of interest comes in. When you pay back the money you owe, you also have to pay a little bit extra as interest.
But how much interest do you have to pay?
Well, it’s not a fixed amount, instead, the lender will want a percentage of the original loan amount to be paid back per period on top of the amount itself. This percentage is what we call the Interest Rate.
It’s not all bad though. When you invest your money with someone, you’ll normally be given an interest rate for your investment. This number lets you know how much money you’ll be receiving in interest on top of your original investment amount.
How do Interest Rates Work?
When you take out a loan or invest money with someone, you’ll be informed of the interest rate on that money. The higher the interest rate is, the more money you’ll pay/receive. The interest rate will be presented as a percentage and will be calculated off of the principal amount and (potentially) any unpaid interest.
When you borrow money, you will need to pay back the interest as well as the principal amount. When you invest money, interest will be paid to you instead. If, for example, you have an interest rate of 10% on a R100 debt payment, you will be expected to pay back the original debt alongside an additional 10% of that amount, ie, R110 in total.
For the most part, this interest can be split into one of two categories – Simple or Compound. Depending on the category, the interest can be either static or more fluid.
- Simple Interest – This is interest that is only calculated based on the principal amount. In other words, if you receive 10% simple interest monthly on a R100 investment, you will end up receiving R10 per month in interest.
- Compound Interest – This interest is calculated off of the principal amount and any interest that has been reinvested into the account. In other words, if you receive 10% compound interest monthly on a R100 investment, you will receive R10 the first month and R11 the next month because the second interest payment will be calculated as 10% of R110.
Compound interest, therefore, has a habit of increasing over time so long as it is left alone.
What is an Example of Interest Rates?
If we use the above category of simple interest, you can imagine an example like this –
|A man takes out a car loan from the bank.
The bank offers him R500 000 at a rate of 2.25% simple interest charged yearly for 2 years.
Each year, the man will have to pay 2.25% of R500 000 (R11 250) in interest to the bank.
Over the course of those 2 years, the man will spend R22 500 on interest for his loan.
With an interest rate of 2.25%, the man has ended up paying the bank back R522 500 for his loan of R500 000.
Obviously, these numbers aren’t what you’d expect to see in real life, interest rates can be far higher and can be charged monthly or compounded to raise their price.
Hopefully, though, you can now understand how interest rates affect the amount of money paid to the lender. If we increased the rates to 7.5% in the same scenario, the man would end up paying an extra R75 000 to the bank in interest.
If you struggle with maths, you can always look online for helpful interest calculators which will do the hard work for you.
Why do Interest Rates Change?
Interest rates can change due to a number of factors. The main elements at play include –
- Inflation – Interest rates tend to rise alongside the level of inflation. If the country goes through a period of inflation, you can expect to see higher interest rates across the board.
- Supply and Demand – The supply of funds/credit available to lenders and the amount of demand they receive from their customers will impact the interest rates on loans. When there is a surplus of available credit and not many people asking for it, interest rates tend to decrease. However, when supply is limited and the demand is high, interest rates increase.
- Policy – The Reserve Bank is able to affect interest rates to achieve certain goals. Generally, this is done to influence inflation throughout the country.
Is a High or Low-Interest Rate Good?
It depends on who’s asking. If you’re the one lending money out, a high-interest rate is better because it means that you’ll be earning more money when the loan is paid back to you.
By contrast, if you are the person receiving a loan, a lower interest rate is better because it means that you’ll have to pay a smaller amount of interest back to the lender.
In Conclusion – What are Interest Rates and How do they Work?
Interest rates indicate what percentage of your principal you will be paying back/earning in interest per period. Simply put, when a lender gives out a loan, they generally expect some interest to be repaid to them in addition to the loan itself. This is, for instance, how banks make money from giving out loans.
The amount of interest you have to pay back with your loan will normally be calculated as a certain percentage of the original amount of the loan. This percentage is known as your interest rate and lets you know how much interest will be accumulated on the principal.
Interest can be split into two main categories – simple and compound.
Simple interest is calculated solely on the principal amount. In other words, 10% simple interest paid monthly on a R100 loan would amount to monthly payments of R10.
By contrast, compound interest is based on the principal amount as well as any reinvested interest that has developed over a certain period. In other words, 10% compound interest paid monthly on a R100 loan would give you R10 in the first month, and then R11 in the second month because the second interest payment would be calculated off of R110 (principal plus interest) rather than off of the original R100.
Interest rates can be affected by various factors which may cause them to rise or fall. The main factors include –
- Inflation – Interest rates will increase and decrease alongside inflation.
- Supply and Demand – The supply of funds/credit from lenders coupled with the demand for supply/credit from consumers will help to determine the interest rate.
- Policy – The Reserve Bank can affect interest rates to influence inflation.
Generally speaking, higher interest rates are good for the lender but bad for the borrower, while lower interest rates are bad for the lender but good for the borrower.
Disclaimer Finance101: All of our posts are for research purposes only. Finance 101 aims to assist its readers with useful information on the laws of our country that can guide you to make financial decisions that will enable you to become more financially independent in the future. Although our posts cite the constitution in many instances, they are intended to assist readers who are looking to expand their knowledge of the law & finance-related queries. Should you require specific legal/financial advice we advise you to get in touch with a qualified financial expert.
Found this article interesting? Leave us your thoughts below