Aqib Qureshi
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An interest rate is a fundamental concept and plays a crucial role in the world of finance. It is the return which is earned on invested funds over a specified period.
There are many types of interest rates depending on various financial instruments. Understanding different interest rates will help you to make quick decisions when investing, borrowing, etc.
In this article, you will learn about the terminologies of different types of interest rates which will help you to get a clear view and avoid making mistakes.
Let us begin to know about the types of interest rates.
Simple interest is an easy method of calculating interest on principal amount. It evaluates the charges on principal sum for a specific period.
Let us understand with the help of an example.
If Mr. A deposit Rs.5000 in bank and the bank offers simple interest at 4% p.a., the interest after 1 year will be Rs.200.
SI = [P*R*t]/100
The principal amount is the sum deposited.
Rate of Interest is interest offered to depositors.
Time is denoted in years.
In Compound Interest, the interest is calculated on the total amount including the sum from previous years rather than just principal amount.
Let us understand with the help of an example.
If Mr. A Deposit Rs.100 in the bank and the bank offers compound interest at 5% p.a., the interest after one year will be Rs. 5 and total balance will be Rs.105.
Now, in the next year the interest will not be on the principal amount but on the total balance which is Rs.105
Simple interest grows based only on money you deposit but Compound interest grows based on principal amount and the interest received in previous years. (Edward Elgar Publishing, 2000)
It is a crucial concept which helps in evaluating the present value of future cash flows. It helps to know about the fact that money received in the future is worth less than received in the present.
Discount rate is used to analyse the risk involved in the investment and potential return.
Higher discount rate implies preference should be given to current cash and lower risk tolerance, which makes future cash flow less valuable.
Lower discount rate implies, more preference should be given to future cash flows and indicates high risk tolerance. Selecting the appropriate discount rate will help the individual to make correct investment decisions. It is based on the principle of ‘Time Value of Money’. (Cost-benefit analysis 1994)
It is the fixed annual interest rate of a bond. It is annual coupon payments paid by the issuer to the bond’s face value.
A bond issuer decides the rate based on market interest rates, as the rates change from time to time.
Bond’s coupon rate is usually fixed through the maturity of the bond. The value of bond increases or decreases when the interest rates move lower or higher than the coupon rate. (Liquidity Assessment Facility LAF3.2 2009)
Yield to Maturity is a rate of return on a bond if it is held until it matures. This method enables the investor to compare different securities and the expected returns. Also allows the investors to understand the changes that can affect the portfolio.
Yield to maturity is only a prediction. If the bond is sold before maturity, the actual yield will differ from the yield of maturity. (Journal of Economics and Finance Education)
A fixed interest rate, also known as fixed rate, is an unchanging rate and remains constant throughout the entire period.
It is attractive to people who do not want fluctuations in interest rate because of the changing in market conditions. This type avoids risk which comes with variable interest rates.
Borrowers are likely to choose fixed interest rates when the interest rate in the market is low.
The decision to choose the interest rate depends on the financial position of an individual, their risk tolerance etc.
Internal Rate of Return is the annual rate of growth that an investment is expected to generate. It is a discount rate which makes the net present value of cash flows equal to zero.
The higher an internal rate of return, the more desirable an investment is. When comparing different investment options, the investment with higher internal rate of return is considered the best.
It helps in analysing the capital budgeting projects to understand and compare rates of annual return over time. IRR can help investors determine the investment returns of different assets.
Floating Interest Rate is also known as variable interest rate as it changes periodically. The interest rate moves up and down reflecting the market conditions.
Interest rate depends on the benchmark which is beyond the control of the parties. One of the most common reference rates to use is London Inter-bank Offered Rate.
Floating rate loans often cost less than Fixed rate loans. These rates provide flexibility to both borrowers and lenders.
They are commonly used in adjustable-rate mortgages, floating-rate bonds, etc.
Annualized Rate of Return is a measure used to know the average annual growth rate of an investment over a specific period of time. It helps the investors to compare different investments.
The rate of return considers the compounding effect of investment returns.
There are several types of interest rates which are used according to different financial instruments. Each type has its own implications for borrowers, investors.
The decision to choose the appropriate interest rate also depends upon the financial capacity of an individual.
Understanding the types of interest rates will help to play a vital role in shaping the financial landscape of an individual.
Disclaimer: Investments are subject to market risk, Please read all documents carefully and anything mentioned above is not advised and consult a financial advisor before taking any decisions.
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