Whether on a mortgage, a credit card or a business loan, financial institutions take great pride in advertising their low, low interest – unless, of course, they’re advertising how much interest they’ll pay you if you invest with them. Ignore the hype, because not all interest rates are calculated equally. An understanding of the various types of interest rates can help you make the best decisions for your financial situation.
Simple interest represents the most basic type of rate. Simple interest is paid only one time and does not change. For example, if you borrow $100, the “principal,” for one year, at a “term,” or rate, of 10 percent, after a year you’d owe $110. To calculate simple interest, multiply the principle by the rate and the term.
Compound rates charge interest on the principal and on previously earned interest. For instance, if you borrow $100 at a rate of 10 percent for a term of two years, you’ll owe interest of $10 at the end of the first year and $11, or interest on the first year’s total of $110, at the end of two years, bringing the total interest owed to $21. Compound interest rates are often used for credit cards and savings accounts.
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Amortized rates, common in car or home loans, are calculated so borrowers pay a larger amount of interest and a smaller amount of principal at the start of the loan. As time passes, the amount of principal paid each time increases, shrinking the principal and therefore the amount of interest charged on it. Thus, the amount of interest charged on the principal decreases over time while the interest rate stays the same.
A fixed interest rate stays the same over the life of a loan. Often used in mortgage or other long-term loans, fixed rates are pre-determined.
Variable interest rates change depending on an underlying interest rate, usually the current index value. Commonly used current indexes include the Cost of Savings Index and the 11th District Cost of Funds Index. Variable interest rates are used on loans such as adjustable rate mortgages, or ARMs. Variable interest rates usually change weekly or monthly, and can increase or decrease.
The prime rate refers to the interest rate that commercial lenders use with their best – or most credit-worthy – customers. This rate is based on the federal funds rate, or a daily rate that banks use when they borrow and lend funds with each other. Though large corporations are normally the recipient of prime rate loans, the prime rate affects consumers, as well; personal, mortgage and small business loan interest rates are influenced by the prime rate.
When the Federal Reserve Bank makes a short-term loan to a financial institution, they apply an interest rate known as discount. Discount rates are based on cash flow analysis, which takes both the time value of money and the risk of future cash flow projections into account.