What Is the Interest Rate? All Types Explained

The interest rate is the cost you pay for borrowing money. The interest rate is a percentage of the total borrowed amount. If you take out a loan to buy a house, car, or personal belongings, you are also required to pay interest on it. If you put money in the bank, it is like lending money to the bank, so you will get interest. The interest rate set by the bank determines the amount of interest you pay to the bank or the bank to you. Depending on the definition, the interest rate can have different types, such as simple, compound, nominal, real, effective, etc.


Types of interest rates


Simple interest rate

“Simple Interest Rate” (SI) is the interest rate that is calculated by multiplying the daily interest rate by the principal amount of the loan by the number of days remaining until maturity.


Compound interest rate

Some lenders prefer a “Compound Interest Rate” to lend financial resources because, with this method, more interest can be received from the person applying for a loan. Compound interest is also called interest because the interest rate is applied not only to the principal amount but also to the accumulated profits of previous periods.

The bank assumes that at the end of the first year one must pay the principal amount along with the interest rate for that year. Also, the bank assumes that at the end of the second year, the borrower is obliged to pay the principal amount and the interest rate of the first year, and the interest rate accrued on the interest of the first year. The interest that the borrower is obliged to pay by compounding will be more than the simple interest.

Interest may be accrued monthly on the principal amount and interests of the previous months. In shorter time frames, the calculation of simple and compound interest will be similar, but with the increase of the loan period, the difference between the calculation of these two types of interest increases.


Interbank interest rate

“Interbank Rate” refers to the interest rate applied on short-term loans between banks. In economic literature, due to the short term of these loans (within 24 hours), the rate assigned to them may also be called the “overnight rate”. The interbank lending market is a market in which banks lend money to each other for a specified period.

Most interbank loans have a maturity of a week or less, and may even have a daily maturity. These loans are granted at interbank interest rates. Banks are required to maintain a certain amount of cash assets under the title of “Reserve Requirement” so that they do not lose their credits if a large number of customers come to withdraw their deposits.

If a bank does not have access to the minimum amount of liquidity, it borrows in the interbank market to cover this deficiency. On the other hand, some banks with excess cash reserves grant loans to other banks in the interbank market at an interbank interest rate. The interest rate of the interbank market depends on the availability of money, certain conditions of lending (conditions mentioned in the contract), and prevailing interest rates.

There is a wide range of interbank interest rates, which include the “Federal Funds Rate” in the United States, and the “London Inter-Bank Offered Rate” (LIBOR) in England. And “Euro Interbank Offer Rate | Euribor” was mentioned. The interbank interest rate also affects the base interest rate – the rate at which commercial banks lend to their most reliable customers.


Nominal interest

When issuing bonds, bond issuers declare a rate as nominal interest rate, which is the annual interest paid to the bondholder as a proportion of the nominal value of the bond. Therefore, the nominal interest rate is obtained by dividing the annual interest payment by the nominal price of the bond.


What is the effective interest rate?

Most of the bond issuers pay the interest related to the bond in 3-month or 6-month intervals, which allows the investor to reinvest the received interest and increase his yield. Therefore, the investor’s interest rate, in this case, will be different from the declared interest rate.


Floating interest

It is an interest rate that changes with the change of factors such as market interest rate, stock market index, inflation rate, etc. This interest rate can be called a variable or adjustable interest rate.


Fixed interest

This type of interest rate is the opposite of a floating interest rate, where the interest rate on the debt is fixed for an agreed period.

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