Different Types Of Interest Rates And How Does Interest Rates Work
Interest is an essential aspect of the financial markets that appear in nearly all aspects of people’s financial life. In most cases, it is the grease, which ensures credit card companies and lending trains continue to lend money to clients.
What is an Interest Rate?
Interest is simply the additional amount that a borrower has to pay on top of the principal borrowed. It is also the percentage charged by a lender for the use of its money. Expressed as a percentage, the interest could be fixed amount or sliding scale, often referred to as variable amount.
Financial institutions and lenders apply interest rate on the total unpaid portion of a loan or credit balance. Depending on the type of loan or credit taken, you must pay at least interest each month to avoid further debt accumulation.
Read More: Why do Central Banks change Interest Rates
Types of Interest Rates
Fixed Interest Rate
A common type of interest rate, fixed interest refers to the amount of interest that must be repaid along with the principal. In addition to being easy to calculate, they are stable, allowing borrowers to calculate in advance the amount they must pay back over a long period. In this case, both the borrower and lender understand the rate obligations tied to a loan.
Variable interest are the opposite of fixed interest as they fluctuate. The rate at which the interest rate fluctuates depends on the movement of the base interest rate as set by the central bank. Whenever the base interest rate declines, then the variable interest tends to follow suit-allowing borrowers to pay less in interest.
Likewise, whenever the base interest rate rises, lenders also tend to increase the variable interest rate forcing borrowers to pay much more interest on borrowed money. Banks deploy variable interest rates to protect themselves from varying economic cycles in the market.
Annual Percentage Rate
The annual percentage rate refers to the total interest on the total cost of a loan expressed as a percentage. Credit card companies deploy this type of interest rate whenever consumers decide to carry a balance on their credit card account.
The Prime Rate
Financial institutions also try to entice their favored customers to take loans by offering friendly interest rate. The prime rate in this case, is an interest rate that tends to be relatively lower than the prevailing base interest rate, in the overall market. The prime rate is often offered to encourage borrowing.
The Discount Rate
The discount rate is the interest rate that the U.S Federal Reserve charges financial institutions when it lends money to cater to short term needs. Banks rely on the discount rate to borrow money to cater to daily funding shortages as well as address liquidity issues.