What is an interest?

What is 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 into 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're lending or borrowing money. But before you start, here is a premium training that will allows you to know all the secrets to succeed in the Podcast.

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?? 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 behind. the bank.

It is calculated as a percentage of the balance of a loan (or deposit), periodically paid to the lender for the privilege of using his money. The amount is usually stated as an annual rate, but interest can be calculated for longer or shorter periods than one year.

Article to read: Everything you need to know about money market accounts

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.

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?? How does interest work?

There are two basic types of interest: simple interest and compound interest.

simple interest

Simple interest, or flat rate 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 borrowing 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. Suppose you borrowed $1000 from a bank. If your loan generates an annual interest rate of 10% at the bank, 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 amount of interest may be higher or lower if you borrow money over a longer or shorter period.

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

For example, if you put $1 in a savings account that pays 000% interest per year, you will earn $2 in interest, which will give you $20 after one year.

Again, the interest you earn may be higher or lower if the interest rate changes. Overall, what you earn or pay depends on:

  • 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 is the future value of the loan or investment, including interest; P is the principal investment amount; r is the annual interest rate (decimal); n is the number of times 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

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

?? 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 want to lend money.

Obtaining a point of equilibrium with the association of these two variables establishes the value of the interest rate. Although the market is not the only indicator of its value, there are other important variables as well. These variables are:

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

Also, the central bank of the country sets an interest rate which affects all the above-mentioned factors. Its control allows it to apply expansionist or restrictive economic policies by reducing or enlarging it.

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Types of interests

Here are some forms of interest rates that one could have:

  • Lender interest rate: price charged by a person or credit institution for the money they lend
  • Le Fixed interest rate. It is applied during the repayment period of a loan, the value of which is fixed at the time of the conclusion of the loan.
  • Floating interest rate. It is the one that is paid during the term of a loan and which varies according to a reference interest rate
  • le Interest rate on deposits. Price that a credit institution must pay for the money it receives as a loan or deposit
  • Interest rate in case of rebuttal: interest rate applied on the balance due

?? 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 if 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 settled at 2%.

The nominal interest rate is numerically higher with the duration of the loan: 12% per annum, which is equivalent to 6% semi-annually, or 2% every two months, or 1% per month.

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

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Effective annual interest rate

Also called equivalent annual interest rate, it is a compound interest rate. It includes the nominal interest rate, bank charges and fees, as well as the duration of the operation.

This rate corresponds to the full compensation that the financial institution receives for having lent us money. Like the nominal interest rate, the effective annual interest rate depends on the period during which the interest is paid. Check out this article to know how to reduce your bank charges.

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It is very important that you ask your financial institution if there are any prepayment penalties in the event that 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 classical financial system. In the Islamic financial systeme, this practice is prohibited and considered riba. But riba is Haram. with Islamic finance, you can benefit from interest-free loans.

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2 comments on “What is an interest?"

  1. Good evening Dear Sir and congratulations for all this work that I have just discovered. Where can we find all these works in Cameroon?

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