What is Interest in Finance? - Definition, Calculation, Examples

Updated:30 Sep, 2022

The word interest is used in everyday life, by the way, the meaning of interest is to be curious about something. But 'Interest' in finance means something else. Come let us know about your interest by taking our curiosity together. 

When we keep our money in the bank, the amount goes increases after some time by some percentage, but how this amount has been increased, who deposited more money in the account? This might be the question that may arise in your mind. Here comes the role of interest. The increase in money is due to the rate of interest offered by the bank. This is typically expressed in the Annual Percentage Rate (APR). 

Let's explore some of the common terms that may help us understand the interest further. 

Principal, the amount given to the borrower by the lender is called the principal amount. In this case, the amount deposited by you (lender) to the bank (borrower). Time, for how much time the money is lent to the borrower. In the above case, for how much time amount is deposited in the bank(borrower) by you (lender). 

What is Interest in Finance?

It is the extra amount or monetary charge that you pay when you borrow money from a lender (a personal or a banking institution) or it is the extra money you get when you lend money to someone. This interest is everywhere when you default on your credit card payment, you take a personal loan, car loan, educational loan, and many others. Similarly, you can get interest for your money when you give money to others for example in Fixed Deposit, Savings account, or even when you give money for business purposes. The interest is generally calculated on yearly basis but it can also be calculated semi-annually, or quarterly. There are some types of interests that need to know about:

Nominal: This type of interest is calculated on the principal amount. The interest rate does not change even when the principal amount increases or decreases. 

Real: This type of interest is similar to nominal but it also has part of inflation in it. It is calculated by subtracting inflation from nominal interest.

Effective: This type of interest allows the lender to earn more money than the other one as it includes interest on periodic payments. 

Calculation of Interest

There are two types of interest calculation which is popular in the public domain: Simple Interest and Compound Interest.

Simple Interest (SI): 

It is easy to calculate simple interest as it works directly on the given sum. The principal is constant every time. The formula of simple interest is Principal x Interest rate of interest x Time. Let's suppose a loan of 10000 has been granted at a rate of 5% per annum for 3 years. Then Simple Interest will be (10000 x 5% x 3)= 1500.

Compound Interest (CI)

Compound Interest is interest on interest. It is costly for the borrowers but good for savings or investment purposes. The principle varies during the entire period. The formula for calculating compound interest = Principal (1+ rate)Time -1. For the same scenario as above, the Compound Interest will be 10000[(1+5%)3 -1] = 1576.25. which is more than SI. Any type of investment made is subjected to CI.

What are Negative Interest Rates?  

Negative interest rates mean when the interest rate is paid to the person who borrowed the money rather than the person who lended it. These negative interests are also a kind of monetary policy in which interest rates are below 0%. Also, when there is a strong sign of deflation the Central banks and regulators use this policy in order to balance things properly. 

What are the Determinants of Interest Rates?

Although there are many factors that determine the interest rates but these 12 are the ones that are considered to be the most important

  • Credit History
  • Credit Score
  • Loan Type
  • Length of the Term
  • Employment Income and Type
  • Lon Sise
  • Loan Value
  • Property Type
  • Payment Frequency
  • Debit Ration
  • Co-borrowers 
  • Availability of Documentation

No Interest Financing:

If you are getting a loan on zero interest then it might be a good deal to accept as you have to only pay the principal amount back. But why would anyone give a loan at zero interest these days? The answer like simple they show that they were not charging any interest from you but ultimately you are going to pay some extra charge. 

Understand this with the help of No-cost EMI(equated monthly installment), you have seen on your retail shop or websites like Amazon that they are offering no-cost EMI on any purchase. This works in two cases,

Example: Suppose the cost of your laptop is 20000, and as soon as you click on no cost EMI. The price of the laptop starts showing 20000 to 23000. 

Now you will feel like 23000 laptops and interest is zero. But shops will give interest to the bank from their pocket and you have to pay 23000. That's why you should check how much this phone will cost you without an EMI. In the second case, there is an interest of 3000 but the company pays that interest as an Interest discount so the laptop price will remain at 20000. But remember the interest are subject to GST which is not paid by the company also the EMI processing fees of the bank are to be paid by you. So, when you pay monthly EMI you have to pay the GST amount applicable to your interest, which will eventually cost more than 20000. 

Lastly, interest can be said as a fee for using others' money. It is always recommended to read all the papers regarding the loans thoroughly and check the interest, principal, and period before borrowing the money which can save you from any future headaches. All the borrowing must be under Simple Interest and all investing under Compound Interest. Also, do not fall into the trap of instant loans from any app or website do take a loan from a reputed financial institution by visiting their branch. 

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