Understanding Fixed Income: Interest Rates
What is Interest Rate?
Interest Rate is the percentage at which your money makes money when you lend your money to someone and they pay you for the loan.
For example, when you put your money in a Savings Account, you give the bank your money. In return, the bank gives you interest for that money. This way you are making money.
“But, why would a bank pay someone for keeping their money safe?” thought Jonah
The reason a bank is able to give you interest, is because it takes the money you deposited, and lends it to someone else for more money. This way, the bank is making money also.
How is interest rate calculated?
There are two types of interest rates:
Simple Interest: Where the interest is calculated as a percentage over the entire amount and only done once. Let’s say Edna loaned the Mayor’s wife $100 and agreed that 1 year later she would give it back to Edna and pay her for the loan with an additional 10% in interest, when year 2 comes, the Mayor’s wife will simply return back the money she took from Edna and add the loan percentage of 10%. Hence Edna ends up one year later with $100 + 10% interest= $110.
Compound Interest: This is when you get interest on your interest. It works a bit differently from simple interest as the calculations are made several times through the year. Let’s say that the Mayor’s wife wanted some money again. Edna agreed to lend her $100 but wanted to charge interest of 10% however it is charged every month! In this case, the interest charged every month would be 10/12= 0.83% per month.
In month one, Edna would charge the Mayor’s wife 0.83% so the total owed to her is $100 + $0.83 = $100.83
In month two, Edna would again charge the Mayor’s wife 0.83%. But this time she would charge it on the previous total. $100.83 + 0.83% = %101.66
At the end of 1 year, there would have been 12 charges of 0.83% instead of one charge of 10%. The total that Edna would get is $110. 47
This way, the Mayor’s wife would pay 47 cents more for the same loan!
While Cumulative Interest is what you want when you are lending money. It’s not the best thing when you have borrowed money!