What is an interest?

Interest is the cost of using someone else's money. When you borrow money, you pay interest. When you lend money, you earn interest. Interest is both the cost of borrowing funds and the profit that accrues to those who deposit funds in Saving account.

Calculated as a percentage of the loan or deposit balance, interest is paid to the lender by the borrower in the case of a loan or by the financial institution to the depositor in the case of a savings account. Here, you'll learn more about interest, including what it is and how to calculate how much you earn or owe depending on whether you lend or borrow money. But before you get started, here's a premium training that will help you allows you to know all the secrets to succeed in the Podcast.

Definition of interest

Interest refers to two related but very distinct concepts: either the amount a borrower pays the bank for the cost of the loan, or the amount an account holder receives for the favor of leaving money with the bank. It is calculated as a percentage of the balance of a loan (or deposit), paid periodically to the lender for the privilege of using their money. The amount is usually stated as an annual rate, but interest can be calculated for periods longer or shorter than one year.

In reality, interest is additional money that must be repaid on top of the original loan or deposit balance. To put it another way, consider the question: what does it take to borrow money? The answer: more money. There are two basic types of interest: simple interest and compound interest.

simple interest

Simple interest, or flat interest, is calculated as a percentage of the principal balance of a deposit or loan. No matter how long a borrower goes without paying a debt or an account holder keeps money in the bank, interest will always be calculated from the original amount.

When borrowing: After you borrow money, you will have to repay what you borrow. Also, to compensate the lender for the risk of lending to you, you must repay more than you borrowed.

Take this example. Let's say you borrowed $1000 from a bank. If your loan earns the bank an annual interest rate of 10%, you will repay $1000 plus 10% interest ($100). So, $1 is the amount you will have to repay after one year.

Please note: The total interest amount may be higher or lower depending on whether you borrow money over a longer or shorter period of time.

When loaning: If you have extra money available, you can lend it to yourself or deposit the funds into a savings account, allowing the bank to lend it out or invest the funds. In return, you expect to earn interest. If you don't earn anything, you may be tempted to spend the money instead, as there is little benefit to waiting.

For example if you place $1 In a savings account that pays 2% interest per year, you will earn $20 in interest, which will give you $1020 after one year. Again, the interest you earn may be higher or lower if the interest rate changes. Overall, what you earn or pay is a function of:

• Interest rate
• Amount of the loan
• How long does it take to repay

Compound Interest

With compound interest, accrued interest is added to the principal balance. Think of it as interest on interest. The formula for calculating compound interest is: A = P(1+r/n)^(nt), where A corresponds to the future value of the loan or investment, including interest; P is the amount of the principal investment; r is the annual interest rate (decimal); n is the number of times the interest is compounded each year; and t is the term of the loan. Apparently, Albert Einstein humorously called compound interest the most powerful force in the universe.

Take this example

Looking have $5 in your savings account that pays an annual interest rate of 5%. Compounded monthly, the value of this investment after 10 years can be calculated as follows: P = 5, r = 000, n = 0,05, t = 12. We have A = 10 (5 + 000 / 1) ^ (0,05 (12)). The account balance after 12 years would be $10.

Factors influencing market interest rates

Like goods and services, the interest rate depends on the law of supply and demand. In other words, it is established by the market. Thus, the lower this interest rate, the greater the demand for financial resources.

Conversely, the higher it is, the lower the demand for these financial resources. However, in the case of supply, the relationship with the interest rate is direct because the higher it is, the greater the predisposition to lend money, and the lower the interest rate, the less you will want to lend money. Obtaining an equilibrium point with the association of these two variables establishes the value of the interest rate. Although the market is not the only one that indicates its value, there are also other important variables. These variables are:

• The real interest rate on public debt.
• Inflation expected.
• The liquidity premium.
• Interest risk of each maturity.
• The issuer's credit risk premium.

In addition, the country's central bank sets an interest rate that affects all the above factors. Its control allows it to apply expansionary or restrictive economic policies by reducing or expanding it.

Types of Interest

Ah, interests! It’s a topic that may seem a bit dry at first, but is actually fascinating when you look at it more closely. Let’s talk about it in a more accessible and concrete way. Let’s start with the simple interest. This is the most basic type of interest, a bit like the kids' menu of the financial world. Imagine you lend a friend 100 euros. You agree that he will pay you back 5% interest per year. After a year, he will owe you 105 euros. Simple, right?

Then, we have the compound interest. This is where it gets more interesting (no pun intended!). It's as if your interests themselves had small interests. Let's go back to our example: if your friend keeps the money for a second year, you don't just calculate 5% on 100 euros, but on 105 euros. It may seem trivial, but in the long term and with larger sums, it makes all the difference!

There are also the ifixed and variable interests. Fixed interest is like a solid marriage contract: the rate doesn't change, no matter what. Variable interest is more like an open relationship: the rate can go up or down depending on market conditions. Let's not forget the pre-tax and post-account interest. Withholding taxes are like paying the bill before you eat: you receive the interest at the beginning of the period. Post-payments, it's the opposite: you pay after enjoying the service.

Finally, there are the nominal and real interest. The nominal rate is the one you are told, all nice and shiny. The real rate takes inflation into account. It is a bit like the difference between your gross salary and what actually arrives in your bank account.

Ultimately, understanding these different types of interest is a bit like learning the rules of a new game. Once you master them, you can really start having fun (or at least making your money work smarter)! Do you have personal experience with any of these types of interest?

What are the types of interest rates?

Interest rates are applied in different ways, for different periods of time. It is therefore important that you know what type of rate you are being charged. Also whether the interest will be paid at the beginning or at the end of the credit. The most commonly used interest rates are the nominal interest rate and the effective annual interest rate or equivalent.

Nominal interest rate

This rate is simple interest. It corresponds to the percentage that will be added to the initial capital as compensation for a certain period of time, which does not have to be one year.

A nominal interest of 10% compounded semi-annually means that every six months, the interest is paid at 5%. If the nominal interest is 12% and it is compounded every two months, this means that every two months the interest will be paid at 2%. The nominal interest rate is numerically higher with the term of the loan: 12% per year, which is equivalent to 6% semi-annually, or 2% every two months, or 1% per month.

In general, banks tell us the monthly nominal interest rate when they grant us loans. They do this with the objective that we think they are charging us very little money for the credit they grant us.

Effective annual interest rate

Also called the equivalent annual interest rate, this is a compound interest rate. It includes the nominal interest rate, bank fees and charges, and the term of the transaction. This rate corresponds to the full compensation that the financial institution receives for lending us money. Just like the nominal interest rate, the effective annual interest rate depends on the period over which the interest is paid. Check out this article to learn more how to reduce your bank charges.

It is very important that you ask your financial institution if there are any prepayment penalties in case you decide to make a capital payment to reduce the interest generated by the debt. What you need to keep in mind is that the practice of interest is only done in the conventional financial system. In the Islamic financial system, this practice is forbidden and considered as riba. But riba is Haram. With Islamic finance, you can benefit from interest-free loans.

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