What is an Interest Rate?

An interest rate is a percentage of the principal amount of a loan that is paid for the use of the loaned funds. For example, an annual payment of $6,000 for the use of a $100,000 loan is a 6% interest rate. A reasonable interest rate is derived from the market interest rate, plus the perceived ability of the borrower to pay back the funds. If the lender considers the borrower to be high-risk, then it will charge a higher interest rate on any loans extended to the borrower, to compensate it for the risk of not being paid back.

Simple Interest

Simple interest is a method of calculating interest where the interest is earned or paid only on the original principal amount over time. It is determined using the formula:

Simple Interest = P × r × t

where P is the principal, r is the annual interest rate, and t is the time in years. Unlike compound interest, simple interest does not accumulate on previously earned interest, making it easier to calculate and predict. It is commonly used for short-term loans, car loans, and savings accounts where interest is applied in a straightforward manner.

Compounded Interest

If the interest rate is compounded, this means that the borrower owes not just the interest rate on the original debt, but also on any accrued interest. This situation favors the lender, who can earn substantially more than the base interest rate by forcing a borrower to accept frequent compounding, such as every month or quarter.