What is an Interest Rate, Definitions & Examples


Payments on loans are divided into two parts. The first part is called principal which is the actual amount that is borrowed and the second part is called interest rate which is a certain percent of the principal that the lender pays to the borrower. So basically, interest is an additional amount that the lender has to pay to the bank or any other financial institution along with the principal.

Some Interesting Guidelines & Tips of Interest Rate Types

Different banks and financial institutions have different interest rates. It is usually represented as a percentage. Following is a review of a few types of interest rates that you will come around in your journey to applying for a loan.

What is Prime Interest Rate?

The U.S. banks charges prime interest rates to its most efficient customers. It is a common and short spanned rate. Prime rates are based on federal fund rates. To make it profitable banks and other financial institutions add or subtract to these rates accordingly.

Banks usually raise the prime rate by up to 4.5 percent. On 14th June 2017, the fed raised its rate up to 1.25% and just a few hours later the prime rate was raised to 4.25% by the U.S. Bancorp.

To make it easier to understand we can use the example of the Home Equity Line of Credit. If a comparison is drawn between the current HELOC rates of different users it will be observed that the rate is high in a few and low in others while some have the exact same rate as the prime interest rate.

What is FED Interest Rate?

Federal Fund rates commonly known as the fed rates are the interest rates banks charge each other overnight. The fed funds are used to control inflation for a better economy and are set up by the Federal Open Market Committee of the Federal Reserve System.

The importance of the fed interest rate is such that whenever this rate changes all the other rates blindly follow for it may be the foreign exchange rates or any other. Banks make more loans when the fed interest rates are low and when they are high the chances of better interest rate saving account brightens.

What is Mortgage Interest Rate?

Mortgage interest rates, as the name depicts, are applied on Mortgages. The Consumer Financial Protection Bureau explains mortgage rate as the annual interest rate applied on the borrowed money. It is different for different banks.

Some banks offer fewer mortgage rates than others, so, to make the perfect decision it is advised that you view different mortgage rates of different banks before coming to a conclusion.

Types of Saving Interest Rates:

Saving accounts are meant to secure your future and therefore it is very important that you understand well what type of saving interest rate is your best option. Saving interest rates change as per our economy. The two different kinds of Saving Interest Rates are as follows:

  1. Simple Interest rate: Simple interest is basically the profit you gain by investing money. The formula for finding simple interest rate is I=Prt where P represents the principal, r represents the rate and t represent the time. So, if you invest $1000 at the rate of 3 annually you will earn $30 in interest.
  2. Compound Interest: Compound interest rates are applied to the initial principal as well as the interest of the deposits and loans. The formula for calculating compound interest is a little complicated I=P[(1+r) ^n-1]. So, in the case of Compound interest if you have $1000 saved up for a year at the rate of 3 will get you $30.42 which is $.42 more than the simple interest rate.

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