What is an interest rate?
An interest rate is the amount a lender charges a borrower when they take out a loan. The loan taken to pay off a purchase, like a mortgage or car, is known as the principal sum. Therefore, the interest rate is calculated as a percentage on the principal amount, charged over a specified period of time.
When taking out a loan to start a business, it’s important to consider how interest rates will affect the total amount of money you’ll need to pay back. You may consider a variable interest rate, sometimes called a “floating rate” which fluctuates over time since it’s tied to a specific financial index. Variable rates are common on credit cards, private student loans and even mortgage loans, typically called adjustable-rate mortgages. Conversely, a fixed interest rate refers to a lending rate that’s permanent for the term of the loan.
You can learn more raising money for a business in our guide to business funding.
In savings accounts, you can earn interest on the amount of money you deposit in a financial institution. Some institutions may offer savings accounts with a high interest rate to entice customers.
A change in interest rates can affect everything from credit cards, mortgages and private loans as well as influence prices at the gas pump or supermarket. Here’s what you need to know about calculating interest rates for your personal or business bookkeeping.
Before signing off on a loan, it’s essential to fully understand the interest rate and terms and conditions from the lender. In most cases, a borrower who is considered low risk by the lender will have a lower interest rate and a borrower who is high risk will have a higher interest rate. Some factors that determine lender risk include:
Length of loan term
Employment type and income
How to calculate interest rates
There are two ways to calculate interest rate: simple and compound. To find the simple interest rate, begin from the principal amount and multiply it by the interest rate and the loan’s term. The formula is this:
Simple interest = principal x interest rate x loan term
For a $5,000 loan with a 2% annual interest rate over 3 years paid monthly, the simple interest rate calculation would be 5,000 x 0.02 x 3, which comes out to $300. This is the amount of simple interest to be paid off on top of the principal loan over 3 years.
Compound interest works a little differently. In this case, a borrower pays interest on top of interest, meaning they pay both on the principal amount and on the interest that accumulated since the beginning of the loan term.
Here’s how that looks:
Compound interest = P(1+i)t - P
P - Principal
i - Annual interest rate
t - term period
For the same $5,000 loan with a 2% interest rate over 3 years compounded annually, the compound interest rate calculation looks like: 5,000(1+0.02)3-5,000, which comes out to $306.04. The compound interest added a few dollars onto the total interest to be paid back, which might seem trivial, but when added to larger loans or with shorter compounding periods, the fees add up quickly. When it comes to borrowing money, having compound interest means the total amount to pay back may be significantly higher than a loan with simple interest.
However, Compound interest could be a good thing if you’re gaining money, as seen in a high-interest savings account. But when it comes to borrowing money, having compound interest means the total amount to pay back may be significantly higher.
For example, let’s say you want to create a savings account with an institution that offers compound interest: You initially open an account and deposit $1,000, with a 1% compound interest fee. Furthermore, you deposit $500 each month to increase your savings. The compound interest is calculated on the initial deposit, the interest earned each month, and the monthly deposits. Over 25 years, you will have deposited $151,000 of your own money—but earned an additional $20K+ due to compound interest.
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Interest rate examples
To better understand interest rates, let’s look at another example: A small business owner wants to take out a $500,000 loan from a bank to help launch their business idea. The borrower goes to two different banks offering different interest rates through their business banking services with the same term of 25 years.
The first bank offers the borrower a loan at a simple interest rate of 3% on the principal amount. With the formula for simple interest rates, the borrower calculates that they'll need to pay back $375,000 in interest over 25 years, in addition to the principal amount borrowed—so $875,500 in total.
The second bank offers them a loan with a compound interest rate of 2.5% over the same period of time. They calculate that with this offer, even though the interest rate percentage is lower, they will end up paying >$425,000 in interest because it’s been compounded over 25 years—or ~$927,000 in total.
This $51,500 difference shows why understanding how different interest rates work is critical. In other words, what may initially seem like a good deal could end up costing you more depending on whether the interest rate is simple or compound.
APR vs interest rates
When considering loans and interest rates, it’s common to find lenders that mention an APR either instead of or alongside an interest rate on the amount borrowed. While the two terms can be used interchangeably, they mean slightly different things and should be examined individually when calculating the cost of a loan.
The Annual Performance Rate (APR) refers to both the annual cost of the principal loan in addition to any fees associated with the loan. So when both the interest rate and APR are mentioned in relation to a loan, an APR is normally slightly higher. Both are presented as percentages, but an APR will be either the same or higher than the stipulated interest rate by at least 0.1% to 0.5%.
The APR includes various fees associated with a specific loan. For example, on a house mortgage, the APR includes broker fees, mortgage insurance, discount points and closing costs. Thus, calculating the overall APR rather than taking the interest rate alone is a better way to manage expectations on total costs when taking out a loan.
As a result, an APR may be a more accurate representation of what a borrower can expect to pay in total on a specific type of loan, like a mortgage. According to the U.S. federal Truth in Lending Act, all creditors and lenders providing consumers with loans need to list the APR along with the interest rate to remain transparent and protect borrowers against inaccurate and unfair billing practices.