What is Interest?
By
Bradley Songer on October 5, 2010
Anytime you borrow money from a lender an interest rate is applied. It is basically the fee to borrow money or assets from a lender. Many people choose to borrow money in order to buy products they need or a‘now’ instead of ‘later’. Therefore, interest is the price paid for the use of borrowed money. Intaerest is typically paid to the lender as a percentage of the amount owed. Thus, 10% interest on $100 is $10. The percentage of the principal that is paid as a fee over a certain period of time (typically one month or year) is called the interest rate.
Interest is essentially the compensation that the lender receives for their risk of investment loss. Also, by allowing the borrower to temporarily borrow funds, they are forgoing other possible investments that could have been made with the loaned asset. This is also known as an opportunity cost. Instead of the lender using the assets directly, they are given to the borrower to utilize. The borrower then uses the borrowed assets to buy the products they require or desire ahead of time, while the lender is paid by the borrower the interest as compensation.
There are several types of interest available. A simple interest rate is used on loans with a single payment. Interest is calculated on the amount of the loan during the time period for which the money is borrowed. The effective rate is the same as the stated rate. It is interest that is calculated on a sum that does not include previous interest charges. Compound interest means that each time interest is received on an interest bearing investment it is added to or compounded into the investment principal and thereafter also earns interest. For example, a bank deposit balance is estimated each day for daily compounding. Common compounding periods are daily, monthly, quarterly, annually and continuously. The more frequent the compounding period, the higher the effective rate of interest. A fixed interest rate loan is a loan where the interest rate doesn't fluctuate during the fixed rate period of the loan. This allows the borrower to accurately predict their future payments. A floating interest rate, also known as a variable rate or
adjustable rate, refers to any type of debt instrument, such as a loan, bond, mortgage, or credit that does not have a fixed rate of interest: instead, the interest rate may fluctuate with the prime rate.