Types of Interest

1. Fixed Interest Rate
2. Variable Interest Rate
3. Annual Percentage Rate
4. Prime Interest Rate
5. Discounted Interest Rate
6. Simple Interest Rate
7. Compound Interest Rate

• The types of interest are fixed interest rate, variable interest rate, annual percentage rate (APR), prime interest rate, discounted interest rate, simple interest rate, and compound interest rate.
• When borrowing money, the debt has two components: the principal, which is the amount borrowed, and the interest, which is an additional charge representing the cost of borrowing and serves as income for the lender.
• Compound interest is calculated based on the loan's principal and accrued interest. Banks typically apply the interest to the loan balance, and the remaining balance is used to determine the next period's interest payment, creating a compounding effect over time.

Debt comes from two components, i.e., principal and interest. The principal is the actual sum of money borrowed by the business or individual, and the interest is the additional charges, which are, in a way, a form of income for the lender to provide the debt.  Interest comes in various forms, and its primary types include Fixed Interest, Variable Interest, Annual Percentage Rate, Prime Interest Rate, Discounted Interest Rate, Simple Interest, and Compound Interest.

A fixed interest rate is the most common type of interest rate, which is generally charged to the borrower of the loan by lenders. As the name suggests, the interest rate is fixed throughout the loan's repayment period. It is usually decided on an agreement basis between the lender and the borrower when the loan is granted. This is much easier, and calculations are not at all complex.

• It gives a clear understanding to the lender and the borrower what the exact amount of interest rate obligation is associated with the loan.
• Fixed interest is a rate that does not fluctuate with time or during the loan period. This helps in the accurate estimation of future payments to the borrower.
• Though one drawback of a fixed interest rate is that it can be higher than variable interest rates, it eventually avoids the risk that a loan or mortgage can get costly.

Example

A fixed interest rate can be a borrower who has taken a home loan from a bank/lender for a sum of $100000 at a 10% interest rate for a period of 15 years. This means the borrower for 15 years must bear 10% of $100000 = $10000 every year as the interest payment. Thus, with the principal amount constantly every year, he has to pay $10000 for 15 years. Thus, we see no change in the rate of interest and the interest amount which the borrower has to repay the bank. Thus, it makes it easy for the borrower to plan his budget accordingly and make the payment.

A variable interest rate is just the opposite of a fixed interest rate. Here the interest rate fluctuates with time. Variable-rate interest is generally linked to the movement of the base level of interest rate, which is also called the prime rate of interest. Borrowers end up on the winning side if the loan has opted on a variable rate of interest basis, and the prime lending rate decreases.

• In this case, the borrowing rate also goes down. This generally happens when the economy is passing through a crisis. On the other hand, if the base interest rate or the prime interest rate rises, the borrower is forced to pay a higher interest rate in such scenarios. Banks will purposely do such to safeguard themselves from interest rates as low as that the borrower ends up giving payments, which are comparatively lesser than the market value of the interest for the loan or debt.
• Similarly, the borrower has an added advantage when the prime rate of interest falls after a loan is approved. The borrower does not have to overpay for the loan with the variable rate assigned to the prime interest rate.

Example

Suppose the borrower is given a home loan for 15 years, and the loan amount sanctioned is $100000 at a 10% interest rate. The contract is set as for the first five years, the borrower will pay a fixed rate of 10 %, i.e., $10000 years, whereas, after five years, the interest rate will be on a variable basis assigned to the prime interest rate or base rate. Now suppose after five years, the prime rate increases, which eventually increases the borrowing rate to 11 %. Thus now the borrower pays $11,000 yearly, whereas if the prime rate falls and the borrowing rate becomes 9%, the borrower in such a scenario saves money and only ends up paying $9,000 yearly.

Annual Percentage Rate is very common in credit card companies and credit card mode of payment methodology. Here the annual rate of interest is calculated as the amount of the total sum of interest pending, which is expressed on the total cost of the loan.

• Credit card companies will apply this method when customers carry their balance forward instead of repaying it fully. The calculation of the annual percentage rate is expressed as the prime interest rate; along with this, the margin that the bank or lender charges are added upon.

Example

Suppose we have a credit card with a 24% APR. It means for 12 months, we are charged at a rate of 2% per month. Now all months won't have equal days; thus, APR is further divided by 365 days or 0.065%, which is called the DPR. Thus interest rate finally stands for DPR or the daily rate multiplied by the daily card balance, and then further, this result is multiplied by the number of days in the billing cycle.

The prime rate is the rate the banks generally give to their favored customers or customers with a very good credit history. This rate is generally lower than the usual lending/borrowing rate. It is generally linked to the Federal Reserve lending rate, the rate at which different banks borrow and lend. But again, not all customers will be able to opt for this loan.

Example

Suppose when a big corporation has a regular loan history and very good repayment history, too, with the bank approaching the lender for a short term loan, the bank can arrange for the same at a prime rate and offer it to its customer as a good gesture of relationship.

This interest rate does not apply to the common public. This rate is generally applicable for Federal Banks to lend money to other financial institutions on a short-term basis, which can be as short as a single day. Banks may opt for such loans at a discounted rate to cover up their lending capacity, rectify liquidity problems, or prevent a bank from failing in a crisis.

Example

Suppose, at times when the loans/lending becomes more than deposits in a single day, a particular bank may approach the Federal Bank to grant loans at a discounted rate to cover up their liquidity or lending position for the day.

Simple Interest is a bank's rate of interest for charging its customers. The calculation is basic and generally expressed as the multiplication of principal, interest rate, and the number of periods.

Example

Suppose a bank is charging a 10% rate of interest on a loan for $1000 for three years; the simple interest calculation stands to be $1000 * 10% *3 = $300.

Compound Interest methodology is called interest on interest. Banks generally use the calculation to calculate the bank rates. It is based on two key elements: the interest of the loan and the principal amount. Here banks will first apply the interest amount on the loan balance, and whatever balance is pending will use the same amount to calculate the subsequent year’s interest payment.

Example

For example, we have invested in the bank for $1000 at 10% interest. First-year we will earn $100 and second-year the interest rate will be calculated not on $10,000 but on $10,000 + $100 = $10,100. Thus we will earn slightly more than what we would have earned under a simple interest format.

This has been a guide to Types of Interest and their definition. Here we discuss the list of top 7 types of interest with examples and detailed explanations. You may learn more about financing from the following articles –

• Negative Interest Rate
• Interest Income
• Effective Interest Method
• Gross Interest