What Is an Interest Rate?
The interest rate is the percentage of interest relative to the principal. It is either what lenders charge borrowers or what is earned from deposit accounts.
The interest rate on a loan is typically noted on an annual basis and is expressed as an annual percentage rate (APR).1
An interest rate can also apply to a savings account or a certificate of deposit (CD). In this case, a bank or credit union pays a percentage of the funds deposited to the account holder. Annual percentage yield (APY) refers to the interest earned on these deposit accounts.
Compound Interest Rate
Some lenders prefer the compound interest method, which means that the borrower pays even more in interest. Compound interest, also called interest on interest, is applied both to the principal and also to the accumulated interest made during previous periods. The bank assumes that at the end of the first year the borrower owes the principal plus interest for that year. The bank also assumes that at the end of the second year, the borrower owes the principal plus the interest for the first year plus the interest on interest for the first year.
The interest owed when compounding is higher than the interest owed using the simple interest method. The interest is charged monthly on the principal, including accrued interest from the previous months. For shorter time frames, the calculation of interest will be similar for both methods. As the lending time increases, however, the disparity between the two types of interest calculations grows.
Using the example above, at the end of 30 years, the total owed in interest is almost $673,019 on a $300,000 loan with a 4% interest rate.
The following formula can be used to calculate compound interest:
Compound interest = p x [(1 + interest rate)n − 1]
where:
p = principal
n = number of compounding periods
Let’s look at another example. Jayati takes out a three-year loan of $10,000 at an interest rate of 5%, which compounds annually. In the end, as worked out in the calculation below, she pays $1,576.25 in interest on the loan:
$10,000 [(1 + 0.05)3 – 1] = $10,000 [1.157625 – 1] = $1,576.25