An interest rate is a fundamental concept and plays a crucial role in the world of finance. It is the return which is earned on invested funds over specified period.
There are many types of interest rates depending on various financial instruments. Understanding different interest rates will help you to make quick decisions when investing, borrowing, etc. (Den Haan, W.J., 1995)
TYPES OF INTEREST RATE
In this article, you will learn about the terminologies of 10 different types of interest rates that is broadly used used in the financial world. which will help you to get a clear view and avoid making mistakes.
Let us begin to know about the types of interest rates.
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SIMPLE INTEREST AND COMPOUND INTEREST
Simple interest is an easy method of calculating interest on principal amount. It evaluates the charges on principal sum for specific period.
Let us understand with the help of an example.
If Mr. A deposit Rs.5000 in bank and the bank offers simple interest at 4% p.a., the interest after after 1 year will be Rs.200.
SI = [P*R*t]/100 Principal amount is the sum deposited. Rate of Interest is interest offered to depositor. Time is denoted in years.
In Compound Interest, the interest is calculated on the total amount including the sum from previous years rather than just principal amount.
Let us understand with the help of an example.
If Mr. A Deposit Rs.100 in the bank and the bank offers compound interest at 5% p.a., the interest after one year will be Rs. 5 and total balance will be Rs.105.
Now, in the next year the interest will not be on the principal amount but on the total balance which is Rs.105 Simple interest grows based only on money you deposit but Compound interest grows based on principal amount and the interest received in previous years. (Gotanda, J.Y., 2002)
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Prime Interest rate
Banks frequently provide their most valued customers or those with stellar credit histories the prime interest rate. In general, this rate is less expensive than the going rate for loans and borrowing.
It typically has something to do with the Federal Reserve’s loan rate. This is the lending and borrowing rate for various banks. Not every customer will be able to select this loan, though.
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Discount Rate
It is a crucial concept which helps in evaluating the present value of future cash flows. it helps to know about the fact that money received in future is worth less than received in present. Discount rate is used to analyse the risk involved in the investment and potential return.
Higher discount rate implies preference should be given to current cash and lower risk tolerance, which makes future cash flow less valuable. Lower discount rate implies, more preference should be given to future cash flows and indicates high risk tolerance.
Selecting the appropriate discount rate will help the individual to make correct investment decisions. It is based on the principle of ‘Time Value of Money’.
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Coupon Rate
It is fixed annual interest rate of a bond. It is annual coupon payments paid by issuer to the bond’s face value. A bond issuer decides the rate based on market interest rates, as the rates change from time to time.
Bond’s coupon rate is fixed through the maturity of bond. The value of bond increases or decreases when the interest rates move lower or higher than coupon rate.
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Yield of Maturity
Yield of Maturity also referred as redemption. It is a rate of return on a bond it is held until it matures. It is expressed as an annual percentage rate [APR].
This method enables the investor to compare different securities and the expected returns. Also allows the investors to understand the changes that can affect the portfolio. The formula is complex and requires trial-and-error method to calculate. Yield to maturity is only a prediction. If the bond is sold before maturity, the actual yield will differ from the yield of maturity.
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Fixed Interest Rate
A fixed interest rate, also known as fixed rate is an unchanging rate and remains constant throughout the entire period. It is attractive to people who do not want fluctuations in interest rate because of the changing in market conditions. This type avoid risk which comes with variable interest rate.
Borrowers are likely to choose fixed interest rates when the interest rate in market is low. The decision to choose the interest rate depends on the financial position of an individual, their risk tolerance etc.
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Internal Rate of Return
Internal Rate of Return is the annual rate of growth that an investment is expected to generate. It is a discount rate which makes the net present value of cash flows equal to zero.
The higher an internal rate of return, the more desirable an investment is. When comparing different investment options, the investment with higher internal rate of return is considered the best.
NPV=∑(1+IRR) tCFt
Where:
NPV is the net present value,
CFt
IRR is the internal rate of return, and
t is the time period.
It helps in analysing the capital budgeting projects to understand and compare rates of annual return over time. IRR can help investors determine the investment returns of different assets.
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Floating Interest Rate
Floating Interest Rate is also known as variable interest rate as it changes periodically. The interest rate moves up and down reflecting the market conditions.
Interest rate depends on the benchmark which is beyond the control of the parties. One of the most common reference rates to use is London Inter-bank Offered Rate.
Floating rate loans cost less than Fixed rate loans. These rates provide flexibility to both borrowers and lenders. They are commonly used in adjustable-rate mortgages, floating-rate bonds.
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Annualized Rate of Return
Annualized Rate of Return is a measure used to know average annual growth rate of an investment over specific period of time. It helps the investors to compare different investments. The rate of return considers compounding effect of investment returns.
Annualized Rate of Return= (Beginning Value Ending Value
Where: Ending Value is the value of the investment at the end of the period.
Beginning Value is the initial value of the investment.
Number of Years is the time period over.
For example, suppose you invested 10,000 in a fund, and after three years it grew to 13000.
The annualized rate of return:
Annualized Rate of Return= (1300010000)13−1≈8.65%
CONCLUSION
There are several types of interest rates which are used according to different financial instruments. Each type has its own implications for borrowers, investors.
The decision to choose the appropriate interest rate also depends upon the financial capacity of an individual.
Understanding the different types of interest rates will help to play a vital role in shaping the financial landscape of an individual. (Homer, S. and Sylla, R.E., 1996)
